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How to ensure the eurozone does not unravel

How to ensure the eurozone does not unravel
Simon Tilford, FT 4/10 2006

The writer, head of the business unit at the Centre for European Reform, is author of the pamphlet: Will the eurozone crack?

The euro has to be a success if Europe is to flourish. Unfortunately, diverging trends in competitiveness within the eurozone threaten its stability. If they persist, a break-up of economic and monetary union cannot be ruled out, raising questions over the future of the single market – Europe’s most important force for improved economic performance.

Within a currency union, a country cannot devalue its currency to regain competitiveness but must alter the relative prices of its goods and labour. There is scant labour mobility between eurozone members and no sizeable central budget to even out performance differentials. If the euro is to succeed, members must have flexible labour markets so that real wages (nominal wages adjusted for inflation) can fall relative to other member states and workers can move rapidly from declining to fast-growing industries.

Public finances must be sound so that an economic downturn can be temporarily offset by stronger public spending.

Unfortunately, membership of Emu has, if anything, reduced pressure on governments to undertake reforms. Italy and Germany illustrate this paradox most starkly. Freed from the risk of currency crisis and higher debt service costs, Italy has done little to strengthen its public finances, make its labour market more flexible or boost competition.

German real wages grew by an average of just 0.3 per cent a year from 1999 to 2005, massively boosting the country’s competitiveness and exports but depressing domestic consumption.

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