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The euro area's economy
Beggar thy neighbour
Jan 25th 2007
From The Economist print edition
Germany's economy has regained its lost competitiveness, but it may come at the expense of Spain, where wages are rising fast
Satoshi Kambayashi
THE economy of the euro area is basking in a rare period of optimism. Growth forecasts ended the year higher than at the start of the year, the first time this has happened since 2000. The growth differential with America's economy has narrowed and is expected to contract further this year. But in an economy that comprises 13 diverse nations, such blessings are rarely unmixed. A particular concern is that the recent resurgence at the euro zone's core could portend a protracted slump at its periphery.
Germany has been the source of much of the recent good news in Europe. For so long a laggard in the euro area, its economy is now growing faster than the regional average. Unemployment, though still high, has dropped sharply in the last two years. The latest survey from Ifo, a Munich economic-research institute, shows that business confidence remains close to a 15-year high. Exports and business investment are doing well. Understandable doubts remain about the durability of Germany's revival: consumer spending has so far failed to take off convincingly.
Yet arguably the German economy is on a sounder footing than at any time since reunification (see article). Germany's recovery in cost competitiveness has been crucial to its reviving fortunes. Declining real wages and a modest upswing in productivity have together produced a sustained drop in unit labour costs. Lower wage costs, in turn, have helped boost exports and jobs.
Hope for a lasting German recovery is mixed with concern about the outlook for countries where wage discipline has been less strict. In Italy and Portugal, for example, a combination of strong wage increases and weak productivity growth has undermined cost competitiveness.
The same cocktail of higher wages and sluggish productivity clouds the outlook for one of the fastest-growing European economies: Spain. In the last decade, its economy has expanded by an average of 3.7% a year, nearly twice the rate for the whole euro zone. Spanish demand has been driven by housing and credit booms that are vulnerable to higher interest rates. But high labour costs may in the end prove to be Spain's undoing. In a report published this week the OECD, while applauding Spain's “remarkable” performance, noted that its relatively high inflation had undermined its competitiveness.
Olivier Blanchard, of the Massachusetts Institute of Technology, sees Spain as a plausible next victim of what he calls “the rotating slumps under the euro”. In his view, the euro area is characterised by a succession of booms and busts, each in a single country. A typical stop-go cycle starts with a localised increase in demand, which in turn leads to higher wages, lost competitiveness and finally to a protracted downturn. Since short-term interest rates in the euro area are not tailored to individual countries' cycles, monetary policy can attenuate neither boom nor bust.
In Mr Blanchard's model, the slump migrates across the currency zone according to shifts in relative wage costs. A long period of above-average wage growth that goes unmatched by productivity gains will eventually leave a country at a significant cost disadvantage.
Germany's recent history shows how hard it is for a member of the euro club to recover from a cost-induced slump. Devaluation might have been an obvious remedy, but can only be achieved by leaving the currency union. The only other solution is to drive down wage costs relative to those in competing countries. This option is also costly: Germans have paid the price in terms of high unemployment and stunted growth. Cost reduction is also painfully slow. Workers are resistant to pay cuts, so the necessary reduction in real wages relies on a long period of below-average inflation. This kind of wage discipline has underpinned Germany's revival.
An increase in productivity growth, a more recent trend, has given German competitiveness a further boost. Output per hour in Germany rose by 2% last year, according to a report published on January 23rd by the Conference Board, a business organisation. Such vigour has put further distance between Germany and its trading partners to the south. Spain's performance is particularly dismal. Output per hour there fell by 0.5% last year, continuing a negative trend that dates back to the mid-1990s.
For Mr Blanchard, Spain is at a potentially dangerous point in the relative-cost cycle. Wages are still rising at a rate roughly twice the euro zone's average and well ahead of productivity growth. Spain's real exchange rate is up by nearly a quarter since 2000 (see chart). But so far the economy shows few symptoms of ill health. GDP probably grew by 3.6% last year and forecasts for this year suggest only a modest slowdown.
One clear sign of something amiss is Spain's current-account deficit, which widened to 8.8% of GDP last year, estimates the OECD. Such imbalances can reflect shifts in competitiveness and warn of trouble ahead—especially, perhaps, in a currency union where the costs of wage adjustment are high. Within America, by contrast, cost imbalances are resolved less painfully, because workers are willing to move from depressed states to where jobs are more plentiful.
Portugal's ballooning trade deficit in the late 1990s was a symptom of declining competitiveness and the economy has yet to recover from the subsequent bust. Spain now has the second-largest current-account deficit in the world in dollar terms and looks dangerously overheated. Germany's resurgence has set a challenge for the euro zone's southern members. Without the option of devaluation, their medium-term outlook looks less than rosy.
Beggar thy neighbour
Jan 25th 2007
From The Economist print edition
Germany's economy has regained its lost competitiveness, but it may come at the expense of Spain, where wages are rising fast
Satoshi Kambayashi
THE economy of the euro area is basking in a rare period of optimism. Growth forecasts ended the year higher than at the start of the year, the first time this has happened since 2000. The growth differential with America's economy has narrowed and is expected to contract further this year. But in an economy that comprises 13 diverse nations, such blessings are rarely unmixed. A particular concern is that the recent resurgence at the euro zone's core could portend a protracted slump at its periphery.
Germany has been the source of much of the recent good news in Europe. For so long a laggard in the euro area, its economy is now growing faster than the regional average. Unemployment, though still high, has dropped sharply in the last two years. The latest survey from Ifo, a Munich economic-research institute, shows that business confidence remains close to a 15-year high. Exports and business investment are doing well. Understandable doubts remain about the durability of Germany's revival: consumer spending has so far failed to take off convincingly.
Yet arguably the German economy is on a sounder footing than at any time since reunification (see article). Germany's recovery in cost competitiveness has been crucial to its reviving fortunes. Declining real wages and a modest upswing in productivity have together produced a sustained drop in unit labour costs. Lower wage costs, in turn, have helped boost exports and jobs.
Hope for a lasting German recovery is mixed with concern about the outlook for countries where wage discipline has been less strict. In Italy and Portugal, for example, a combination of strong wage increases and weak productivity growth has undermined cost competitiveness.
The same cocktail of higher wages and sluggish productivity clouds the outlook for one of the fastest-growing European economies: Spain. In the last decade, its economy has expanded by an average of 3.7% a year, nearly twice the rate for the whole euro zone. Spanish demand has been driven by housing and credit booms that are vulnerable to higher interest rates. But high labour costs may in the end prove to be Spain's undoing. In a report published this week the OECD, while applauding Spain's “remarkable” performance, noted that its relatively high inflation had undermined its competitiveness.
Olivier Blanchard, of the Massachusetts Institute of Technology, sees Spain as a plausible next victim of what he calls “the rotating slumps under the euro”. In his view, the euro area is characterised by a succession of booms and busts, each in a single country. A typical stop-go cycle starts with a localised increase in demand, which in turn leads to higher wages, lost competitiveness and finally to a protracted downturn. Since short-term interest rates in the euro area are not tailored to individual countries' cycles, monetary policy can attenuate neither boom nor bust.
In Mr Blanchard's model, the slump migrates across the currency zone according to shifts in relative wage costs. A long period of above-average wage growth that goes unmatched by productivity gains will eventually leave a country at a significant cost disadvantage.
Germany's recent history shows how hard it is for a member of the euro club to recover from a cost-induced slump. Devaluation might have been an obvious remedy, but can only be achieved by leaving the currency union. The only other solution is to drive down wage costs relative to those in competing countries. This option is also costly: Germans have paid the price in terms of high unemployment and stunted growth. Cost reduction is also painfully slow. Workers are resistant to pay cuts, so the necessary reduction in real wages relies on a long period of below-average inflation. This kind of wage discipline has underpinned Germany's revival.
An increase in productivity growth, a more recent trend, has given German competitiveness a further boost. Output per hour in Germany rose by 2% last year, according to a report published on January 23rd by the Conference Board, a business organisation. Such vigour has put further distance between Germany and its trading partners to the south. Spain's performance is particularly dismal. Output per hour there fell by 0.5% last year, continuing a negative trend that dates back to the mid-1990s.
For Mr Blanchard, Spain is at a potentially dangerous point in the relative-cost cycle. Wages are still rising at a rate roughly twice the euro zone's average and well ahead of productivity growth. Spain's real exchange rate is up by nearly a quarter since 2000 (see chart). But so far the economy shows few symptoms of ill health. GDP probably grew by 3.6% last year and forecasts for this year suggest only a modest slowdown.
One clear sign of something amiss is Spain's current-account deficit, which widened to 8.8% of GDP last year, estimates the OECD. Such imbalances can reflect shifts in competitiveness and warn of trouble ahead—especially, perhaps, in a currency union where the costs of wage adjustment are high. Within America, by contrast, cost imbalances are resolved less painfully, because workers are willing to move from depressed states to where jobs are more plentiful.
Portugal's ballooning trade deficit in the late 1990s was a symptom of declining competitiveness and the economy has yet to recover from the subsequent bust. Spain now has the second-largest current-account deficit in the world in dollar terms and looks dangerously overheated. Germany's resurgence has set a challenge for the euro zone's southern members. Without the option of devaluation, their medium-term outlook looks less than rosy.
