Has the global economic crisis saved Europe’s monetary union?  This is the not-unreasonable conclusion that could be drawn from analysis in the European Commission’s forecasts, just released. The Brussels executive’s forecasts for growth and public finances have caught the headlines. But the Commission’s economists also looked at the gaps that had opened up between eurozone economies prior to the crisis - which, with hindsight, were seriously testing the “one size fits all” monetary policy. By then, they calculate, the difference in current account balances was at its highest for more than three decades.

One reason for this gap was that European financial integration had given greater access to international capital markets to countries “engaged in catching-up processes” (read: Spain, Greece and Ireland). The result - cutting a long story short - was fewer constraints on credit and lower real interest rates, which fed through into housing market bubbles and large private sector debt levels.

Then came the crisis and a demand shock which, the Commission’s economists note, was “particularly large in member states with large current account deficits and significant private sector indebtedness”. As a result “the crisis appears to have worked to correct some of the current-account imbalances within the euro area, albeit part of the adjustment may prove to be cyclical and thus temporary.” And the monetary union lives to fight another crisis…

Still, the Commission laments the lack of adjustment in relative price competitiveness, which would help sustain economic convergence (see chart). Its economists write that “with the exception of Ireland (IE), and to some extent Portugal (PT), real effective exchange rates are projected to change relatively little in most member states over 2009-11.”

Tags: divergences, European Commission, eurozone

November 3, 2009 3:12pm in Europe, European Central Bank, asset bubbles, interest rates, trade imbalances | Comment