17 April 2015

Vox EU: Three waves of convergence. Can Eurozone countries start growing together again?

Column authored by Marco Buti and Alessandro Turrini.

Structural convergence presents a basis for renewed real convergence. However, for this to happen, the right institutions and policies need to be in place at both European and national levels.

There is a widespread view that the monetary union is now acting as a straitjacket on countries in the periphery, that it’s no longer delivering convergence in living standards. In this vein, the Euro Summit of 24 October 2014 called for work to continue to "develop concrete mechanisms for stronger economic policy coordination, convergence, and solidarity", and invited the President of the European Commission, in close cooperation with the President of the Euro Summit, the President of the Eurogroup, and the President of the European central Bank, "to prepare next steps on better economic governance in the euro area".

This column argues that convergence in the Eurozone has never stopped – what changed over the main phases of the monetary union was the type of convergence.

The type of convergence currently at work is neither nominal convergence (i.e., convergence in nominal variables like inflation and interest rates) nor real convergence as commonly understood (i.e., convergence in per capita incomes) but a convergence that concerns the structure of the economy.

Structural convergence is posing the basis for renewed real convergence. However, for this to happen, the right institutions and policies need to be in place at the  EU/EZ level and the national level.

The three faces of economic convergence

Different meanings have been given to the term ‘economic convergence’. In growth literature, convergence refers to the expected tendency for countries to grow faster the lower their GDP per capita level. Real convergence (i.e., narrowing differences in terms of per-capita GDP, relative endowments of productive factors and relative factor prices) is what neo-classical growth theory predicts.

The debate at the start of the Economic and Monetary Union (EMU) was also centred around convergence. In particular, the Maastricht criteria emphasised nominal convergence (defined in terms of nominal variables such as interest rates, inflation, exchange rates, government deficits and debt): the objective was not only that of creating a single currency, but also a stable currency (e.g., Buti and Sapir, 1998). It was expected that the adoption of a single currency would give strong incentives to carry out structural reforms to compensate for the loss of monetary policy as a stabilisation tool.

The academic debate put the emphasis instead on Optimal Currency Area (OCA) theory and the extent to which real convergence was sufficiently advanced to make the economies of the countries participating in EMU synchronised, so as to reduce the risk of unaddressed asymmetric shocks in a monetary union. The debate on the possible tension between nominal and real convergence surrounded also EU enlargement, with emphasis on the possible difficulties encountered by accession countries in respecting Maastricht criteria on inflation, interest and exchange rates in light of the operation of Balassa-Samuelson effects (e.g., Grauwe and Schnabl 2005).

Real convergence was implicitly assumed to work in the direction of making the economies participating in the monetary union more similar in terms of economic structures, thereby approaching EMU to the OCA requirements and easing the respect of the Maastricht nominal criteria.

However, the facts proved this expectation wrong. The first decade of EMU showed that structural convergence is not necessary a by-product of nominal and real convergence.

The three waves of convergence in EMU

The run up to EMU coincided with nominal convergence: differences in inflation rates among the countries participating in the monetary union narrowed. The average level of nominal interest rates and their dispersion across ‘EMU-ins’ dropped dramatically, in light of converging inflation differentials, reduced exchange rate risk, and reduced government deficits (see Figure 1).

Figure 1. Interest rates: Mean and variance across EA-12 countries

Source: elaborations on AMECO data

Full article at Vox EU

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