The euro area crisis finds its roots in the credit booms seen in many countries following the introduction of the euro in 1999. Easy credit led to strong growth in a range of sectors, notably housing, as well as higher levels of public spending. Inflation in these over-heating economies was higher than the euro area as a whole. Rising prices led to rising costs and a loss of international competitiveness.
The cost of each unit of output produced (unit labour costs) rose much faster than average over the past decade in credit boom countries like Greece and Spain. In France and Italy, unit labour costs rose when wages grew faster than productivity. The story was different in Germany, where weak domestic demand and wage restraint meant that costs remained more or less flat.
Since the crisis, costs have begun to come down in many countries, as demand has fallen and unemployment has risen. Economies that run external deficits are beginning to rebalance, by slowing down wage growth, lowering export prices and boosting foreign demand. At the same time, wages in Germany are rising faster than elsewhere, as they catch up to the stronger performance of the economy in recent years.
This necessary adjustment is underway, but not yet complete. The OECD predicts that costs will continue adjusting over the coming two years, bringing relative costs among euro area countries in line with their 2000 levels. This would be an encouraging sign that the euro area is moving out of the crisis.
Unfortunately, most of the adjustment so far has stemmed from weak domestic demand and high unemployment. Most euro area countries still need to implement further structural reforms to make their economies more efficient while restraining wage growth. Germany should implement policies that lead to further adjustment of relative costs and demand.
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