Increasingly there is a divergence between different blocks of countries within the EU. Some economies are showing signs of economic recovery. Others (the likes of Portugal, Ireland, Greece and Spain) are facing an unwelcome combination of stagnant growth, high unemployment, unpopular spending cuts, budget crisis and current account deficits.
Another useful graph is the divergence in unit labour costs. Previously if Greece saw rising wages, it would probably lead to a depreciation in Greek currency. But, now that can't happen - leading to the record current account deficit. To deal with uncompetitiveness it is necessary to require a much more painful process of deflation and lower growth.
I've often posted about the inherent problems of a single currency for a two speed Europe (basically you can set monetary policy for two different economic regions)
However, are there any practical problems with the two speed Europe?
- Fiscal transfers, e.g. from Germany to Greece. This would help solve budget crisis without the need for so much austerity. Fiscal transfers could help reduce geographical unemployment. To some extent the UK did this when unemployment was higher in north of UK than south during the 1980s. However, German tax payers are unlikely to want to fund 'the profligacy of their neighbours' It's one thing to give funds to different regions in your country. But, to give funds to other countries who beat you at football and speak another language is really stretching to the limits of European idealism. - Also there is a danger of moral hazard. If they pay up now, it may keep happening in future.
- Supply side policies to regain competitiveness. Reducing labour market regulation, reducing power of trades unions, reducing benefits may all help put downward pressure on wages and restore competitiveness. However, it would be wrong to expect too much from supply side reforms. For example, Ireland already has one of lowest levels of labour market regulation in EU. Definitely structural unemployment is a problem for Spain, but it's only part of the problem, there is also the fundamental lack of demand in economy.