Prior to the introduction of the euro, European economies running big trade deficits routinely devalued their currencies against the Deutschmark and other currencies tied to it. This prompted allegations of beggar-thy-neighbor activity and even calls for protectionism.
One of the key arguments for the euro was that it would put an end to these so-called “competitive devaluations,” opening the way for a deepening of the European Union’s single market and improved economic growth.
But competitive devaluations between members of the eurozone are alive and well and arguably pose a bigger threat to the single market — and with it to the future of the euro — than currency flexibility ever did
Germany is often held up as an example of how to deal with the rigors of the euro. But this is a parochial view of what has happened.
Eye-watering German wage restraint — German wages, adjusted for inflation, have barely risen in a decade — has boosted the price competitiveness of German-made goods within the currency union, while holding back German imports.
In short, Germany has been free-riding on demand generated elsewhere in the eurozone. This is not healthy “system competition” between members of the currency union, but a “competitive devaluation” in all but name.
It is a zero sum game: Germany has been able to rely on wage restraint because others have not.
Germany’s beggar-thy-neighbor strategy poses a bigger threat to the single market than the currency devaluations engaged in by Italy and others prior to the introduction of the euro.
The earlier currency flexibility was far from ideal, of course: German firms and those based in the countries with currencies linked to the Deutschmark protested every time the lira or peseta lost value.
However, at least these currency movements facilitated rebalancing between E.U. economies. The devaluing economies were able to regain competitiveness and ensure that their economies continued to grow. Revaluation boosted the disposable incomes of German consumers by cutting the prices of imported goods, but it also meant that Germany could not afford to ignore domestic demand.
By contrast, Germany’s ongoing competitive devaluation within the eurozone has helped to create imbalances; it is not a response to them.
There may have been some justification for German wage restraint during the first couple of years of the euro. At this point Germany was still digesting the implications of unification — the addition of 10 million relatively unproductive East German workers pushed up pan-German unit wage costs.
But that justification long since ceased to be valid, to the extent that it ever was. German wage restraint has not boosted investment — and hence employment and consumption — in Germany. This is hardly surprising, as outside of the export-orientated sectors of the economy, demand is simply too weak. Germany has become almost totally dependent on exports and investment in export-orientated sectors of its economy for economic growth.
There is little the eurozone’s deficit countries can do to force Germany to rebalance its economy. As members of the currency union, they cannot devalue in order to reverse the competitive gains eked out by German wage deflation. The E.U. has no power to question the wage-setting policies of eurozone governments or tell the German government what it needs to do to boost domestic demand.
Nor is the European Commission about to gain such powers: Stronger eurozone governance will comprise little more than a beefed-up system for ensuring budgetary discipline.
Therefore, the only option the deficit countries have is to cut wages by more than the Germans. This is all but impossible: German wages (taking account of inflation) are on course to decline in 2010, as they did in 2009. Even if the deficit countries could reduce wages more rapidly than the Germans, it would simply lead to a eurozone slump and almost inevitably deflation.
The impact of the euro on the single market has so far been disappointing, and the European Commission is right to argue that much closer economic integration between the members is essential. This would increase competition and with it productivity and economic growth.
It would also lessen the risk of a one-size-fits-all monetary policy by narrowing the differences in productivity growth and inflation rates among the participating economies.
But if the member-states running big external deficits cannot rebalance, they will oppose moves to deepen the single market, such as freeing-up trade in services within the currency bloc. Why risk a further leakage of demand to the bloc’s surplus economies? They may even start questioning existing elements of the single market.
The currency flexibility of the pre-euro period was untidy and offended European purists. But it facilitated adjustment between the economies and enabled the European economy to continue growing.
What would be preferable for European economic prospects (and hence German exporters) — a Spain that could rebalance and return to growth or one mired in indefinite stagnation?
Simon Tilford, chief economist at the Centre for European Reform.