Germany’s silent rebalancing, Covid, and EMU

Donato di Carlo and Martin Höpner recently posted a very interesting piece on the Europp blog. Bob Hancké takes a look at their main arguments and explains the consequences of Germany's silent rebalancing for EMU from a practical and theoretical perspective.

The argument in a nutshell: the differences in wage bargaining systems in the eurozone were one of the causes of the EMU crisis in the early 2010s. Germany and its economic satellites in northern Europe kept export prices under control, while southern Europe, lacking such coordinated wage-setting arrangements, essentially lost competitiveness. The result was a divergence between the two, a balance of payments crisis ensued, and a currency crisis followed.

In their blog post Di Carlo and Höpner suggest that after the crisis a silent rebalancing between the north of Europe around Germany and the south of Europe had taken place since then. But, thus the upshot of the blog post, the Covid-19 crisis has upset that slow and silent but steady adjustment process.

If they are right, that spells serious trouble for EMU. Assuming that this divergence in wages (adjusted for productivity, ie unit labour costs) reappears, it follows logically that EMU should get ready for another currency crisis. Declaration of interest: I was among the first to make that point, both concentrating on the mechanism of wage divergence and predicting another crisis.

Despite the tragedy that this will produce for EMU, it will at least allow us to settle one part of the debate. Many of my colleagues have said that this wage-centred argument mistakes the froth for the coffee. What drove the crisis were financial markets: capital flows from the competitive north to the uncompetitive south financed the current account deficits, and when these capital flows suddenly stopped because of the fragility of the banking system, debtor nations were unable to meet their financial obligations.

The problem has always been that both mechanisms (wages v finance as causes of the crisis) were a priori plausible, and that there was no discriminating observation that either camp could think of and both agree on to settle the debate. Attributing causal claims became a matter of what you believed in and not of fact. Hence the importance of Di Carlo and Höpner’s analysis. Without a bank in sight this time, if Covid has stopped the wage convergence of the 2010s and led to a new EMU crisis (though probably not quite the same as the previous one – Marx’s tragedy and farce), we can be fairly sure that finance was not the driver the first time around. We may well need a capital markets union in Europe, a banking union and a single resolution mechanism in that case, but to handle the fall-out of a crisis that started elsewhere. And we should therefore think a bit harder about how stabilise different pressures of wage inflation in the eurozone.

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