Pessimistic views on Eurozone rebalancing are not uncommon (e.g. Darvas 2012). However, in a previous Vox column at the end of 2012, we had an overall optimistic take on the issue, noting the rapid reduction of large current account deficits and a turnaround in unit labour cost dynamics, supportive of adjustment going forward (Buti and Turrini 2012).
With hindsight, Eurozone rebalancing has indeed made some progress, but the optimism of some years ago on rebalancing prospects has not fully materialised.
First, the substantial reduction of most current account deficits has not been matched by progress in terms of reducing large surpluses. Quite the opposite: the combined surplus of Germany and the Netherlands, which explained more than 90% of the Eurozone surplus in 2016, has been growing continuously since 2001 and is projected to start falling in nominal terms only in 2017. As a result of the simultaneous reduction of large deficits and the lack of correction in large surpluses, the Eurozone as a whole has gradually moved to a surplus position exceeding 3% of GDP, reflecting a growing gap between aggregate domestic demand and income which underpins exceptionally low inflation rates. The current account surplus of the Eurozone is estimated above the level that can be justified on the basis of fundamentals according to European Commission estimates (European Commission 2016a), and slightly above according to IMF estimates (IMF 2017a). From a global perspective, the Eurozone surplus almost corresponds to the combined surplus of China and Japan.
Second, the gap in terms of unit labour cost dynamics between surplus and deficit countries peaked around 2012 and has been somewhat eroded since then (Figure 1). A recovery of wage growth from exceptionally low rates in net debtor countries, coupled with missing productivity gains, has played a role, but the lost advantage of net debtor countries in terms of labour cost dynamics is also related to persistent moderate wage dynamics in surplus countries. The persistence of relatively subdued wage growth in surplus countries is to some extend at odds with what could be predicted on the basis of the working of Phillips curves – a tighter labour market in low-unemployment surplus countries should be accompanied by stronger wage dynamics.
Figure 1 Nominal compensation per employees in the Eurozone: Surplus versus deficit countries
Notes: Surplus countries: BE, DE, LU, NL, AT, FI. Deficit countries: remaining EZ19 countries. All surplus countries recorded a current account position balanced or in surplus over the 1999-2012 period (the only exceptions being DE and AT before 2002 and Fi after 2010, while all deficit countries recorded a deficit between 2000 and 2012.
Source: Elaborations on AMECO and Commission Spring Forecast 2017.
What is observed instead since 2014 is a flattening of the Eurozone Phillips curve, with considerable reductions in Eurozone unemployment having taken place with virtually no change in nominal growth rates (Figure 2).1 Such a persistent moderate growth in nominal wages is another factor that hinders the achievement of monetary policy objectives with regards to inflation and that, as pointed out in a previous column, would make the two objectives of Eurozone rebalancing and debt sustainability incompatible (Buti 2014). A multitude of possible explanations have been advanced for the muted upward cyclical reaction of wages, including the role of long lags in revising collective wage contracts, low inflation expectations playing a role in wage contract renewals, reduced labour productivity growth, labour market slack being more serious than revealed by unemployment figures, and a reduction in the wage share due to changing bargaining power of wage setters linked, among other things, to technological change (e.g. European Commission 2016b, ECB 2017, IMF 2017b).
On the basis of the above arguments, one can formulate an impossible trinity as follows: can we have at the same time price stability as defined by the ECB, Eurozone rebalancing, and uncoordinated competitiveness developments?
Figure 2 The Eurozone: Phillips curve relation, 2000-2016
Source: Elaborations on AMECO, EZ19
The current coordination framework and its rationale
After the start of EMU, in view of growing competitiveness divergences and widening external imbalances, there was awareness of the need to strengthen the coordination of policies affecting competitiveness (e.g. Allsopp and Artis 2003, European Commission 2008). It was acknowledged that purely market-driven competitiveness dynamics may not guarantee a sufficiently swift operation of the automatic adjustment mechanism in the face of asymmetric shocks, and that tensions may emerge between the two objectives of internal (output close to potential) and external equilibrium (a balanced current account position, taking into account fundamentals). The current position of the Eurozone and the large members in terms of internal and external equilibrium can be depicted as in Figure 3 using the well-known Swan’s graphical representation in the real exchange rate-output space. While for Germany and the Netherlands a roughly balanced internal position coexists with a large current account surplus, for Italy a current account surplus is matched by output below potential, while France is characterised by a negative output gap and a current account deficit. To achieve both internal and external equilibrium, one instrument is not enough – policies affecting both domestic demand and competitiveness are needed, with combinations that depend on the specific country situations.
In principle, a case for coordination of competitiveness developments builds from two basic considerations. First, while output gap divergences tend to be automatically re-absorbed via the market mechanism – since countries with tighter labour markets tend to exhibit higher wage growth – the market mechanism does not necessarily help external adjustment, and policy intervention may become necessary. Second, since competitiveness is a relative concept and Eurozone countries are highly integrated, the effectiveness of policies to affect competitiveness depends also on what policies are done in partner countries.2
The fact that market-driven competitiveness developments may not necessarily be helpful for external equilibrium is exactly what was observed after the start of EMU, when output above potential in the Eurozone periphery justified relatively buoyant wage growth. Competitiveness losses helped curbing overheating in the periphery but, over time, this process led to growing external imbalances, and the crisis acted as a catalyst for their correction. The crisis also made clear that disruptive current account reversals may take place also inside an incomplete monetary union like the euro area. Consistently, more recently, ideas have also been floated suggesting a structured framework to coordinate policies affecting competitiveness to prevent the building up of large external imbalances (e.g. Sapir and Wolff 2015).
In light of the experience with the first EMU decade, surveillance procedures aimed at enhancing coordination of policies to prevent and correct macroeconomic imbalances were introduced, with the Macroeconomic Imbalance Procedure becoming operational in 2012.
Policy recommendations to adjust current account deficits have focused on the need to improve competitiveness primarily via productivity gains, but also by means of appropriate wage dynamics.
The focus of policy recommendations aimed at fostering adjustment in surplus countries was instead mainly on the need to stimulate investment. The recommendation to use fiscal space in surplus countries has been met with resistance and given rise to a politically charged debate within the Council. Recently, a growing number of commentators (e.g. Bofinger 2015) and policy institutions (e.g. IMF 2017c) have shifted raised the question whether surplus countries should start focusing more on the role that wage dynamics can play in the rebalancing process. Consistently, in 2017 the EU Council recommended that Germany and the Netherlands create “conditions to promote higher real wage growth, respecting the role of the social partners”.
Figure 3 Internal and external (dis)equilibria in the Eurozone
Why coordination helps in the current context
The need for coordination to steer competitiveness developments across Eurozone countries is becoming particularly evident in the current context for a number of reasons.
- First, wage dynamism in surplus countries would help monetary policy achieve inflation objectives while at the same time supporting Eurozone rebalancing. Wage growth in crisis-hit countries is curbed by persistent labour market slack, impaired profit margins, and moderate inflation expectations of wage setters. The pick-up in Eurozone-level wage growth which is necessary to lift core inflation on a sustainable basis will therefore more likely come from countries with tighter labour markets, such as Germany and the Netherlands.
- Second, overcoming wage inertia in surplus countries would help tackle more decisively Eurozone rebalancing by supporting demand. Wage growth in Germany is below what would be predicted on the basis of fundamentals (European Commission 2016c), while consumption as a share of total income is falling. Currently, the difference between the consumption share in GDP in large surplus countries like Germany and the Netherlands and other Eurozone countries has reached record high levels and does not show any tendency to narrow (Figure 4). In net debtor countries and countries with current account deficits, reforms aimed at fostering productivity growth and therefore improving competitiveness would be the necessary complement.
- Third, as opposed to what happened during the first EMU decade, stronger wage growth differentiation would contribute in the present context to both internal and external equilibrium, as labour markets in countries with large current account surpluses are comparatively tighter. Hence, desirable policies would not go against market dynamics, but rather should ensure that such dynamics operate unhindered.
Figure 4 Consumption and investment share in GDP, Germany and the Netherlands versus rest of the Eurozone
Source: Elaborations on AMECO, EZ19
Although wage developments are mainly the result of the interaction between market forces and the institutions underpinning collective bargaining, governments can play a role in affecting relative unit labour costs and competitiveness in a number of ways, including the tax and benefit system (‘fiscal devaluations’), the setting of minimum wages and government wages, the steering of collective bargaining in the private sector via tripartite agreements and social pacts, or, where collective bargaining is regulated by law, the review in consultation with social partners of the legislated frameworks regulating wage setting. In this latter respect, recent reforms have generally focused on reducing obstacles to the decentralisation and articulation of wage bargaining, but, in line with positions echoed in the EMU debate (Calmfors 2001, Blanchard et al. 2013), developments in the direction of strengthened national-level coordination would also help an aligned reaction of wages to cyclical conditions across sectors and firms, which in the current context would also contribute to Eurozone rebalancing.3 Since the above instruments interact in different ways with the rest of the economy, their effectiveness in steering competitiveness developments would differ, as well as their overall impact, and a shared understanding of these effects is a pre-requisite for fruitful policy discussions.4
Although a formal and structured coordination process aiming at the definition of quantitative targets is hardly realistic – and possibly not desirable in light of information gaps, uncertain policy effects, and implementation gaps – an enhanced dialogue at the Eurozone level may ease the achievement of shared objectives and help leveraging existing surveillance instruments.
-Marco Buti, Alessandro Turrini