Many economists, including myself, have argued that there are two crises in the Euro area right now. The one everyone knows about involves government debt. But the other involves competitiveness. Most Eurozone countries (let’s call them non-Germany for short) have allowed their inflation rates to exceed German inflation for a sustained period, which means they are now seriously uncompetitive relative to Germany. This situation will inevitably correct itself. However if German inflation remains low, correction will involve a period of static or falling prices for non-Germany. From experience we know this can only be achieved by high unemployment and low, possibly negative, growth in non-Germany. As a result, many Eurozone countries might be facing or experiencing a recession even if there was no debt crisis.
But does the data support this proposition, which we might call the ‘current misalignment’ hypothesis. The chart below looks at relative unit labour costs (a measure of competitiveness often used by the OECD, whose Economic Outlook is the source for this data) for Germany and the Eurozone as a whole.
|Relative Unit Labour Costs|
The level of either series is arbitrary – its changes that matter. German competitiveness has stayed fairly constant over the last twenty years, but Euro competitiveness has declined sharply since its formation. This implies an even larger competitiveness decline in non-Germany.
So movements in competitiveness since 2000 are clear. However there is an alternative to the current misalignment hypothesis. It could be that the Euro started with an uncompetitive Germany, because Germany joined at an overvalued exchange rate. Let’s call this the ‘past misalignment’ hypothesis. Perhaps what we see now is a return to sustainability rather than a movement away from it. The chart indicates this possibility, with non-Germany gaining competitiveness between 1992 and 2000.
Unfortunately we cannot make the assumption that competitiveness always reverts back to some constant level. For reasons that we do not fully understand, what we call equilibrium real exchange rates (trend or sustainable competitiveness) can show trends over time. So how do we judge what level of competitiveness is sustainable, and what is not? In 1998 I published some work with Rebecca Driver that estimated equilibrium exchange rates for the year 2000. The equilibrium rates we calculated for the Franc/DM and Lire/DM turned out to be close to their Euro conversion rates. This suggests no German misalignment when the Euro was created. At its most basic, what this study did was to look at current accounts.
If a country is too competitive (its exchange rate is undervalued) it will run a current account surplus, and vice versa. The chart below shows a sharp switch from small deficits to large surpluses in the German current account after the formation of the Euro. Non-Germany shows the opposite pattern.
If (and this will be a big if) a sustainable exchange rate is associated with current account balance, then this evidence strongly supports the current misalignment idea. Many have argued (e.g. Martin Wolf in the Financial Times) that current accounts indicate that the Eurozone does indeed have two crises at present. Daniel Gros goes further, and suggests external debt is the key to the current turmoil in European economies.
But is a current account surplus or deficit a sure fire indicator of unsustainable competitiveness? As the current account represents changes in national wealth, we would expect that in a very long run equilibrium the current account should balance. However that is not the case over periods of, say, a decade or two. There are many examples of countries that run persistent current account surpluses: Japan is the obvious example. We understand some reasons why this might happen: a country may have a demographic structure where there are more savers than borrowers (with the opposite bias overseas). Perhaps the formation of the Euro started a period where more capital flowed from the richer to the poorer Euro economies. But if that were the case, would we not also expect surpluses in France, whereas what we find are deficits. Some arguments go the other way. If the need for fiscal consolidation was greater in non-Germany than Germany, this might imply that non-Germany would run larger current account surpluses for some time.
Empirical evidence is rarely clear cut in macro. We cannot know for sure that over the next decade or two Germany will not continue to run large surpluses and non-Germany deficits. But – based on the evidence that I have seen – it does seem unlikely. This past misalignment story seems less plausible and the current misalignment hypothesis more credible. Some interesting implications follow, which I intend to explore later.