ECONOMIC DIVERGENCES IN THE EURO ZONE AND THE DEBT CRISIS
Popović Svetlana[1]
Bošković Olgica[2]
Abstract: At the moment of creation, EMU was not an optimal currency area, nor had all countries met the established criteria of convergence. It was expected however, that the environment of monetary union will facilitate the convergence of economic performances of member states. That did not happen; some euro area countries have experienced a divergence of economic outcomes. There was a divergence of economic performances between two groups of countries: group of mainly Southern European countries - Portugal, Italy, Ireland, Greece and Spain, on the one hand, and countries of mostly Northern Europe - Germany, the Netherlands, Austria, Belgium, Finland, Luxembourg and France, on the other hand.
The lack of economic and fiscal convergence and thus progress toward optimum currency area, together with the lack of political union that would support the project of monetary union, had a consequence that the euro area doesn’t have a sufficient level of homogeneity and that its current form is not sustainable in the long term. Ongoing debt crisis has revealed systemic weaknesses in the functioning of EMU. The countries of the South were not able to cope with their responsibilities and adjust to the environment of monetary union. The problems of refinancing their debts are the result of the imbalances that existed before the crisis - excessive public spending, ineffective use of capital inflows and the loss of competitiveness. Now they are faced with the necessity of implementing a very painful adjustment process that involves structural reforms and budget consolidation, as a condition for adjusting to a common monetary policy.
Exit from the current debt crisis requires a fundamental understanding of its causes. Therefore the following analysis will focus on questions whether countries of Northern Europe form the optimal currency area, to what extent Southern Europe deviate from optimum currency area and what is the extent of differences between them. That is the basis for the choice of the optimal strategies of structural and policy reforms which will make EMU viable.
Given the available data, the method: Testing for individual and time effects has been used, to examine whether there is a statistically significant difference between the observed variables in time and across countries.
KEY WORDS: OPTIMAL CURRENCY AREA, DEBT CRISIS, CONVERGENCE, TEST OF HYPOTHESES WITH PANEL DATA, TESTING FOR INDIVIDUAL AND TIME EFFECTS
1. INTRODUCTION
Optimal currency area is an optimal geographic area for one or several currencies that have been irrevocably fixed. The criteria or the requirements that have to be met by the future members of the monetary union, so that their joining would yield long-term net benefits, had been identified by the scientific theory. In practice, the criteria to join EMU do not match the theoretical requirements of optimal currency area. The requirements are related to the convergence of inflation rates, interest rates, budget deficits, public debt and stability of the exchange rates. When EMU was created it was not an optimal currency area, nor had all the member states met the established convergence criteria. It was expected however, that the environment of the monetary union would facilitate the convergence of economic performance of member states.
European integration is a political project which includes the process of economic and financial integration. Monetary integration was a gradual process that started after a relatively long period, as a continuation of the European economic integration. The events of the ‘90s have revealed the problems with efforts to establish the impossible trinity. Namely, it’s impossible to have an independent monetary policy, fixed exchange rates and free movement of goods and capital, all at the same time. This is why the monetary union is a natural extension of the single market. The solution to the impossible trinity is in the introduction of the common currency, meaning that the members’ exchange rates are irrevocably fixed, in giving up the autonomous monetary policy, which will be transferred to the supranational level and the single market. Euro exchange rate is flexible against other currencies and there is a high degree of autonomy of the European Central Bank regarding monetary policy. That is the solution from the Delors’ report which, in a way, has a protective role - ensuring the stability of exchange rates, which is an additional incentive to strengthen the trading between member states. Not even highly dependent exchange rates could've imposed sufficient monetary discipline, i.e. not even the amended version of the Exchange Rate Mechanism could've yielded good results. The single market couldn't have realised its maximum potential without the single currency. Having a single currency means having a greater transparency of prices, eliminating the currency risks, lowering the transaction costs and increasing the benefits for all member states. Member states had, except for the anchor country, already lost control over their monetary policy due to the mandatory membership in the Exchange Rate Mechanism. This is how member states can participate in the decision making process in relation to the monetary policy.
Contrary to expectations, there was no convergence of economic performance of EMU members. Instead, a process of polarization (divergence) of economic results took place between the two groups of countries – the peripheral or Southern countries and the centre or the wealthier countries, mostly from Northern Europe. EMU is not a homogenous area as a result of that process, and a common monetary policy doesn't fully suit it and can have varied effects on macroeconomic results of individual countries. The debt crisis has accentuated these weaknesses and shown that major changes in the Monetary Union design are needed, as well as that in its present form, it doesn’t have long term sustainability. To create and implement reform, one has to understand the differences between the two groups of countries that are at the core of the current crisis.
2. METHODOLOGY
The purpose of the following analysis is to find out if the process of economic integration between member states in the European Monetary Union had taken place, i.e. if convergence had taken place between the member states – based on relevant indicators, such as indicators of real convergence, nominal convergence and convergence of fiscal policy and fiscal requirements. Convergence of countries by various indicators is often observed through a dispersion index – standard deviation and coefficient of variation. Standard deviation allows for the comparisons between variability in two series of data, only when the values are expressed in the same units and when the arithmetic means of those series are equal. Coefficient of variation is used when the use of standard deviation can't be justified, due to the increase of value of the observed variable over time. In this case, changes in standard deviation will reflect the changes in value of a given indicator across countries, as well as its increase over time. When the differences in values of the observed indicator across countries decrease over time, both standard deviation and coefficient of variation shall decrease. Therefore, if standard deviation and coefficient of variation decrease over the observed period, we can conclude that an approximation process, or rather the convergence process between EMU member states, on that particular criteria, has occurred.
Statistical analysis of disparity in EMU countries was performed on 240 panel data (12 countries, 20 years). Not only will the data enable the analysis of structure and dynamics, but the analysis of changes in structure over time as well. The observed elements shall include 12 member states of the European Monetary Union (EMU 12) in the period from 1991 to 2010. The countries that joined EMU later were not included, because of the small time series data. Due to the short time span, the convergence process cannot be analysed in these countries, i.e. it's impossible to draw valid conclusions from small time series data. 12 EMU countries shall include the existing members without Cyprus, Slovenia, Slovakia, Malta and Estonia. The following indicators were used: GDP per capita, GDP growth rates, output gap, consumer price index, nominal unit labour costs, current account balance, public debt, budget deficit and sovereign debt spread.
Information panel is a combination of data-sectional and time series data of a large number of observations of the same unit at different times. When there are insufficiently long time series of observations or number of units, the classic evaluating technique can not be used. This is a way to avoid the problem of choosing a representative period. Besides, greater variability and higher efficiency rating, the less the likelihood of multicollinearity. The two-dimension structure enables simultaneous analysis of changes in the structure over time (individual and time effects). Test of individual effects is used for testing the significance of differences between individual averages (average of the selected indicators for the entire period 1991- or 1999-2010. by country). The test of time effects is used for testing differences between time averages (average of the selected indicators for all countries analyzed by years).
3. CONVERGENCE PROCESS IN EMU 12
3.1. Real convergence
One of the EMU goals is to have a more even regional development. That means the convergence of development levels between member states. Had that process been realizing, standard deviations and coefficients of variation for GDP per capita would’ve been decreasing over time. Figure 1. is showing the differences in real convergence between Northern and Southern countries, in the last two decades.
Figure 1. Real convergence, GDP per capita (in Euros, 2005=100)
Source: Calculation based on Eurostat data, European Commission, http://epp.eurostat.ec.europa.eu/portal/page/portal/statistics/search_database on 28.1.2012
Until 2003. the achieved development levels, measured by average GDP per capita[3], were slowly converging. After 2003. the trend of continuous and significant increase in disparity started. For the Northern countries in the two decades, the standard deviations of average GDP per capita have mostly been steady, except during the crisis. This means that the convergence of development levels hasn’t been achieved for this group of countries either, although the initial differences were smaller than for the Southern countries, the divergence did not occur. Contrary to the aforementioned, Southern countries had larger differences in development levels, that have been significantly increasing over time. Ireland, whose performance is closer to that of the Northern countries, is at the forefront of this group, while Portugal, whose GDP, on average, is half of Ireland’s GDP, is at the rear. Ireland is the only country that started going through the convergence process upon joining EMU. If we exclude Ireland from the calculation, we can see that the differences between North and South have been constantly increasing[4]. This means that during the last decade there was a divergence in development levels between these two groups of countries.
Figure 2. is showing the average growth rates of the real GDP (by constant prices from 2005.) for the period from 1991 to 2010. In the first years after EMU started, a faster development of the least developed countries was expected, i.e. they were expected to catch up with the more developed members of the euro zone (the catching-up process), and thereby reduce the disparities in development levels within EMU.
Figure 2. Real convergence, average growth rates
Source: Calculation based on AMECO database, European Commission, Economic and Financial Affairs, visited on 16.1.2011 http://ec.europa.eu/economy_finance
Until 2007. Southern countries had, on average, higher growth rates. They were hit harder by the crisis, hence, the negative growth since 2008. Northern countries have previously formed sufficient capacity to exit the crisis faster, and only in 2009. had a decline in economic activity, and already in the following year managed a positive average growth rate. The value of standard deviation is lower in the Northern countries than in the Southern countries, i.e. they generate growth rates that, on average, differ less. (Coefficient of variation for the Northern countries in the observed period, is 5,5% and for the Southern countries it’s 31,5% or 21,4% without Ireland). Since the start of EMU, both groups of countries have shown mild convergence tendencies, but the crisis resulted in divergent movements across the Southern countries.
Although growth rates of the leading economies in the euro zone were lower than the growth rates of the small, open economies, the process of catching up with the more developed member states just wasn’t taking place, except in Ireland. Figure 3. is showing the movement of GDP per capita in EMU member states in comparison with the average GDP in 11 countries (without Luxemburg[5]).
Figure 3.GDP per capita, average in comparison with EMU 11
Source: Calculation based on AMECO database, European Commission, Economic and Financial Affairs, on 16.1.2011. http://ec.europa.eu/economy_finance
The observed countries have a single currency and a single monetary policy, so convergence of growth rates and highly connected economic cycles are needed to achieve satisfactory results. Countries with smaller growth rates will be better suited with a softer monetary policy that can stimulate borrowing, demand and economic activity with lower interest rates. A stimulating monetary policy isn’t appropriate for countries with above average growth rates. It will stimulate demand and may lead to excessive fluctuation and inflation. Nominal interest rates in EMU countries are at a similar level, therefore, higher inflation in individual countries shall result in lower real interest rates. This can initiate a new economic cycle and lead to divergence of EMU countries and increase in rates of inflation as well as cause the differences in its levels to last longer. Considering that the European Central Bank has high credibility, the pressures from the demand may not fully affect the prices, and a speculative bubble may start to appear in certain markets – most of all the real estate market and the securities market, as was the case with Spain and Ireland. Bursting of the bubbles may cause a large scale economic crisis. A more severe monetary policy, that will prevent excessive fluctuation, big hikes in demand and inflation, is better suited for countries with high growth rates. This kind of monetary policy may, however, have serious consequences for the countries with low growth rates, bacuse it can cause deflation. Of course, monetary policy on the EMU level cannot be tailored to individual countries, because there are no instruments to do that, so instead it’s tailored to the Union average. This means that it won’t fully be suited for the fast growing countries or the countries whose growth is beneath the Union average.