In another very good post today Simon Wren Lewis raises the issue of whether European austerity is self defeating. In the course of his piece he makes the point that
a long period of economic stagnation is required in many Eurozone countries to reverse the competitive disadvantage they accumulated relative to Germany in the early years of this century.
However, that is only part of the story. We need to look at economies of the Eurozone as illustrating problems of regional imbalance as well as macro imbalance.
The creation of the Eurozone created one 'national' economy and set up in consequence regional adjustments to the adoption of a single currency which are continuing to work out to this day. The weaker periphery had lower labour productivity and lower wages and that encouraged capital flows from the core countries, mainly Germany, to the periphery. As I wrote in this earlier post
the creation of the Eurozone made it more attractive for investors in the rest of Europe to buy assets in the peripheral countries, where there were, on the face of it, significant investment opportunities. …. These capitals flows worsened an already weak and worsening current account trading position in the periphery because of the high exchange value of the Euro driven by continuing improvements in German competitiveness. Several of the periphery countries such as Greece, Portugal and Spain had, and still have, real efficiency and competitiveness problems, which make it difficult for them in a monetary union led by Germany that has high levels of productivity growth. One saving grace might have been if these investment flows had facilitated an economic adjustment in the periphery sufficient to raise their productivity and competitiveness towards German levels. But they did not, even though the evidence shows …. That the capital flows were associated with investment spending rising in the periphery countries (with the exception of Portugal) relative to consumption.
What we were seeing here is a regional adjustment process that appears to have some of the properties of the regional neo-classical growth models as first considered by George Borts. In these models the returns to factors are eventually equalised as capital and labour flow across regions towards higher marginal returns. Given the production function assumptions, regions with low marginal returns to labour/high marginal returns to capital will attract in flows of capital. Labour will flow in the other direction to higher marginal labour returns. During this process GDP per head should grow more quickly in the regions attracting capital.
The chart below shows a hint of this process after the creation of the Eurozone.
The countries are ranked by ascending GDP per head in 2000 from left to right and the chart shows the growth of GDP. Ireland should really have GNP per head because of the large leakage of multinational profits. Once that is allowed for there is some suggestion that parts of the lower income per head periphery, especially Greece, grew more quickly than the core, especially Germany.
Clearly, other factors such as the differential regional incidence of economies of scale, agglomeration economies, accessibility to markets and other production conditions will have prevented the traditional neo-classical adjustment process. But there is an indication that some convergence was occurring after the creation of the Eurozone, which was halted by the sudden stop of the credit crunch.
What are the implications of this?
It suggests that country/regional adjustment within a single currency area need not simply be about managing aggregate demand differentially. There is a role for stronger regional/cohesion policies to support and effect a more rapid adjustment. Of course these processes take time. Perhaps more time than is available to Greece, Portugal and Spain. But we should not let policy ignore a key economic adjustment process that might help mitigate the pain of contractionary macro-policies in the periphery.