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Concern over euro area divergence

Concern over euro area divergence

Merkel may be thinking: 'Et tu Mario?'

by John Nugée

Wed 27 Aug 2014

The disappointing economic figures from the euro area core economies earlier this month – no growth from Germany, France or Italy in the second quarter – have led to renewed concerns that there is something seriously wrong at the heart of the bloc’s economic policy.

Perhaps the least surprising of the doubting voices was that of Arnaud Montebourg, up to last weekend the French economy minister. His blistering attack – 'these absurd austerity policies which are burying the euro area deeper and deeper in recession' – was unusually direct. This left President François Hollande no option but to dismiss him in the time-honoured tradition of French heads of state: 'I am deeply unpopular and my policies are failing: somebody else must carry the can!'

More significant, perhaps, was the analysis by Nobel laureate Joseph Stiglitz, who said last week that austerity policies in Europe have been a 'dismal failure'. 

But the most important intervention was from Mario Draghi, president of the European Central Bank (ECB). Speaking at the central bankers’ annual gathering in Jackson Hole, he put aside his usual diplomatic support for euro area economic policies. In a speech full of unscripted asides, he emphasised that it was now beyond the powers of the central bank alone to solve the bloc’s malaise.

Draghi quickly left the field of monetary policy and moved to commenting on economic and fiscal policy. Observations such as 'there is leeway to achieve a more growth-friendly composition of fiscal policies', and 'it may be useful to have a discussion on the overall fiscal stance of the euro area' are unusual, not to say brave, from a central bank governor.

This will not be welcome in Berlin, where Draghi has always hitherto been seen as (in public at least) a loyal supporter of the German-inspired economic stance for the euro area. Whoever else may criticise her and her government’s insistence on austerity to right the bloc’s imbalances, Chancellor Merkel has always drawn comfort from the lack of public criticism from Frankfurt.

Now, however, the ECB seems to be saying, 'We have a problem. It is structural not temporary; it is endogenous and self-inflicted because even all the exogenous explanations we can identify do not explain it all. And we, the central bank, cannot solve it on our own.' It seems as though Caesar (or rather the Kaiserin) has now met her Brutus: 'Et tu Mario?' may well be Merkel's greeting next time they meet.

Two observations are worth making. First, Germany may be a victim of the classic challenge of scaling up a successful policy to a larger entity. It is well known that, while frugal living and net saving may be the best policy for an individual family, for a larger community it risks being counterproductive because of the consequent lack of demand. This is the so-called 'paradox of thrift'.

In the same way, a policy aiming at competitiveness and export-led growth, while successful for individual countries, may not be the best policy for a continent-sized bloc. Europe is too large, the evidence suggests, to derive its growth entirely from exports, that is, from the consumption of others. So it needs endogenously created growth from domestic demand and domestic consumption as well.

Second, the flaw in euro area policy may be based on a much deeper faultline. There is a major unresolved difference of understanding at the heart of the euro. There is as yet no complete agreement either on why countries have joined the euro or on what the monetary union is designed to achieve.

Put very simply, Germany and the other northern states see membership of monetary union as a reward for those who have already converged economically. The aim is to help them benefit from the wider market that the euro area offers and help cement and reinforce good economic policies through a 'strength in numbers' approach. The notion is that, if everyone else is virtuous, it is easier for me to follow suit. 

Italy and the other southern states, on the other hand, see euro membership as a tool to help poorer, less developed states converge and catch up, by giving them, inter alia, a strong currency and relief from high interest rates. 

The poorer states thus see membership as more or less the only way their economies will ever converge with the richer states. The richer states, in contrast, view euro adherence as sustainable only for those countries which have already converged.

To put it more starkly, the northern states are setting policy appropriate for a relatively homogenous bloc. The southern states, on the other hand, accept – and wish to overcome – the bloc's evident heterogeneity. The euro's founders ignored the reality that they were dealing with two classes of members with radically different objectives, expectations and understanding of how monetary union would work. 

Many problems stem from the impossibility of overcoming this fundamental divergence. The euro area economy will not be successful until this is aired and a way forward is agreed.

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