Rebalancing the Eurozone

Likewise, while reducing employment is one way to boost productivity, it implies high macroeconomic costs in terms of lost revenues and higher social spending. Perhaps even more importantly, economic policy should not break a society’s confidence in itself; what economists call animal spirits must be able to reflect hope for the future.

For all of these reasons, excessive austerity and deflation could defeat its own purpose and make the reforms to improve the southern European countries’ competitiveness impossible to implement. The right approach must combine reasonable wage restraint and low (but not negative) inflation with microeconomic policy measures aimed at encouraging productivity increases.

Moreover, it is clear that northern European countries could help to close the competitiveness gap more rapidly by encouraging faster wage growth. Indeed, Western policy-makers’ strong focus on persuading the Chinese authorities to permit greater appreciation of their currency is puzzling when one considers that Germany’s current-account surplus, as a share of GDP, is now much larger than China’s.

Reversing the large differential in unit labor costs that has emerged in the euro’s first decade thus requires not only wage restraint and productivity-enhancing reforms in the south, but also higher wage gains in the north. A simulation shows that if German wages grew at 4% annually instead of the 1.5% of the last decade, and if annual productivity growth in Spain accelerated to 2% (it was close to 0.7% in both countries), Spain could reverse the unit-labor-cost differential that emerged with Germany since 2000 in five years, with Spanish wages growing at about 1.7% per annum.

This should not be an impossible scenario. It would require restraint in Spain, where wages grew at an average annual rate of 3.4% in 2000-2010, as well as a serious effort to accelerate productivity growth. But it would not require falling wages or significant price deflation: annual wage growth of 1.7% and productivity growth of 2% would be compatible with inflation close to zero. Productivity growth at the historical rate of 0.7% in Germany, with wage growth of 4%, would be compatible with an inflation rate a little above 3%.

In short, internal adjustment in the eurozone is achievable without serious deflation in the south, provided that productivity growth there accelerates, and that the north does its part by encouraging modestly faster wage gains. The smaller current-account surplus in northern Europe that might result from this should itself be welcome. If the north insists on maintaining the low wage growth of the 2000-2010 period, internal adjustment would require significant unemployment and deflation in the south, making it more difficult and perhaps politically impossible to achieve.

Kemal Dervis, a former minister of economic affairs in Turkey, administrator of the United Nations Development Program and vice president of the World Bank, is currently Vice President of the Brookings Institution.

Copyright: Project Syndicate, 2012.www.project-syndicate.orgFor a podcast of this commentary in English, please use this link:

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