Rebalancing the Eurozone

As long as the eurozone's internal divergence in unit labor costs persists, the euro crisis cannot be fully resolved, because current-account deficits and/or slow growth will continue to stalk the “south,” perpetuating worries about sovereign debt and commercial banks. But the burden of adjustment cannot rest solely on the south.

WASHINGTON, DC – The eurozone crisis unfolded primarily as a sovereign-debt crisis mostly on its southern periphery, with interest rates on sovereign bonds at times reaching 6-7% for Italy and Spain, and even higher for other countries. And, because eurozone banks hold a substantial part of their assets in the form of eurozone sovereign bonds, the sovereign-debt crisis became a potential banking crisis, worsened by banks’ other losses, owing, for example, to the collapse of housing prices in Spain. So a key challenge in resolving the eurozone crisis is to reduce the southern countries’ debt burdens.

The change in a country’s debt burden reflects the size of its primary budget balance (the balance minus interest payments) as a share of GDP, as well as the difference between its borrowing costs and its GDP growth rate. When the difference between borrowing costs and growth becomes too large, the primary budget surpluses required to stop debt from increasing become impossible to achieve. Indeed, growth in southern Europe is expected to be close to zero or negative for the next two years, and is not expected to exceed 2-3% even in the longer term.

While not always evident from the headlines, an underlying cause of the eurozone crisis – and now an obstacle for growth in the south – has been the divergence in production costs that developed between the peripheral countries, notably the “south” (specifically, Greece, Spain, Italy, and Portugal) and the “north” (for simplicity, Germany) during the first decade after the introduction of the euro. Unit labor costs in the four southern countries increased by 36%, 28%, 30%, and 25%, respectively, from 2000 to 2010, compared to less than 5% in Germany, resulting in an end-2010 cumulative divergence above 30% in Greece and more than 20% in Portugal, Italy, and Spain.

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