From comments on an earlier post, it is clear how many people do not understand how a monetary union works. Thinking about it, I also realise that while the macroeconomics involved is entirely straightforward and uncontentious, it may only be obvious to someone who is used to working with models. As I do not want to restrict my readership to those with such knowledge, I thought a brief primer might be useful.
We need to start with the idea that for a country with a flexible exchange rate, you will not increase your international competitiveness by cutting domestic wages and prices. The reason is that the exchange rate moves in a way that offsets this change. This is what economists might call a basic neutrality proposition, and there is plenty of evidence to support it. The Eurozone as a whole is like a flexible exchange rate economy. So if wages and prices fall by, say, 3%, then the Euro will appreciate by 3%.
So what happens if just one country within the Eurozone, like Germany, cuts wages and prices by 3%. If Germany makes up a third of the monetary union, then overall EZ prices and wages will fall by 1%. Given the logic in the previous paragraph, the Euro will appreciate by 1%. That means that Germany gains a competitive advantage with respect to all its union neighbours of 3%, plus an advantage of 2% against the rest of the world. Its neighbours will lose competitiveness both within the union and to a lesser extent against the rest of the world.
That may seem complicated, but to a first approximation it is in fact very simple. The Eurozone as a whole gains nothing: the gains to Germany are offset by the losses of its union neighbours. For the union as a whole, it is what economists call a zero sum game. Germany gains, but its EZ neighbours lose.
One of the comments on this earlier post said that there was nothing in the ‘rules’ to prevent this, the implication being that therefore it was somehow OK. But it must be obvious to anyone that this kind of behaviour is very disruptive, and hardly compatible with Eurozone solidarity. An idea sometimes expressed that it represents healthy competition is wide of the mark. The only incentive it provides is for other countries to try and emulate this behaviour. If they all achieved that, nothing would be gained. The Eurozone inflation rate would, other things being equal, be lower, but other things would not be equal: the ECB would cut rates to try and get inflation back to its target.
The reason there are no formal rules about all this is straightforward: you cannot legislate about national inflation rates. What you could do, to incentive governments, is establish fiscal rules based on inflation differentials of the kind described here. That would have meant that as relative German inflation rates fell, the government would have been obliged to take fiscal (and perhaps other) measures to counteract it. Once again, this is a symmetrical case to what should have happened in the periphery countries. But if rules of this kind had been on the table when the Euro was formed, I’ll give you one guess about which country would have objected the most.