Expert View

Wednesday, 21st December 2011

What is the problem with the Eurozone?

At the formation of the Euro currency it was hoped that it would provide countries with permanent low German-style inflation of 2% pa; reduce the cost of cross-border trade and encourage greater trade within the EU and the Eurozone in particular.

The euro has greatly benefitted business but has also led to great difficulties for countries that could loosely be called Southern Europe, including Ireland.

The problem is that every country has been losing competitiveness compared to Germany. We measure this reduction in competitiveness by looking at the Unit Labour Cost of each Eurozone member. In 2002, when national currencies were transferred into euro, labour costs were fixed against each other.

In the past 9 years, German labour costs have risen by 7%. It now costs €1.07 to produce something in Germany that was produced for €1.00 in 2002. France has managed to maintain its labour costs at the expected inflation rate of 2% pa which means French labour costs are now at 117% of their starting level. Southern Europe’s labour costs are close to 137% of their starting level. All of this represents a frightening lack of competitiveness versus Germany.

Why has Germany alone managed to improve its competitiveness against its neighbours? The answer is that when the euro was born, Germany was struggling to integrate former East Germany, at great cost to itself. Their economic policy was to make individual workers less competitive by holding down wage levels and instead employing more workers to do the same jobs but at the same overall level of wages. This policy has continued and prices in Germany have risen at the rate of wage increases.

It is obvious therefore that German economic policy is at the heart of the instability within the Eurozone and unless it changes dramatically it will beggar all its neighbours.

No monetary union or fiscal compact will succeed if it is based solely on other countries being asked to become more competitive. There has to be a similar move towards wage increases in Germany.