Convergence criteria

Macro Maestro was struck by the way some parts of the media interpreted last week's Euro area GDP data. Several influential commentators argued the large differences in GDP growth, say between Spain (+0.2% QoQ) and Germany (+2.2% QoQ), showed the euro area was 'continuing to diverge'. On the contrary, these data suggest the euro area is finally converging. While we should welcome this from a longer-term persective, unfortunately it's going to involve some pain for a while longer.

Developments in unit labour costs drove the underlying divergences within the euro area over the past decade. With the ECB setting policy rates for the whole region, real interest rates were simply too low for the likes of Spain, Portugal, Greece and Ireland (because of their higher inflation rates). This triggered rapid growth in house prices and huge, ultimately unsustainable construction booms. Employment in those sectors surged, their labour markets tightened and real wages grew out of control.

Higher labour costs made these economies increasingly uncompetitive - their real exchange rates appreciated, notably against Germany. (German companies were still trying to restore their competitiveness following reunification in the early 1990s - an event that, because of the way it was managed, turned a healthy current account surplus into a huge deficit.)

In the past, euro area countries would have addressed their competitiveness problems by devaluing their currencies. But being part of EMU, this is no longer an option. Instead, these economies are going to have to restore competitiveness the hard way.

The latest data suggest this convergence process is now underway. The financial crisis popped the housing bubbles in these smaller euro-area countries, unemployment jumped higher and wage pressures are finally starting to ease. So far, it seems Ireland has made more progress than Spain - largely because the Irish labour market is more flexible.

The bad news, unfortunately, is that this process has a lot further to run. Though construction employment (as a share of the total) has now returned to pre-boom levels, real exchange rates still seem too high for many of the smaller euro-area economies. Until they are lowered, unemployment in these countries seems certain to remain high (and perhaps rise further). In turn, falling real wages should continue to depress consumer demand and aggregate GDP. So GDP data will diverge, as the press point out, but the underlying health of the euro area (and the ECB' ability to manage it) is arguably improving..