The already modest economic recovery in the euro area faltered in the second quarter. Seasonally adjusted GDP remained unchanged in spring. The biggest three euro area economies--Germany, France, and Italy--did not provide any growth impetus, with Germany and Italy contracting by 0.2 percent and France's economy stagnating. Euro area GDP is still 2.4 percent below its pre-crisis level, and indicators suggest only a moderate upward movement in the coming quarters.
Looking at the recovery so far, one could be reminded of a starting aeroplane. It has entered the runway and begun to roll, but it is not yet clear whether the euro area jet will reach the necessary take-off speed. The obvious question, then, is: What can we do to remove ballast, and push the plane into full throttle? Let me start by taking a look at what ballast is still weighing on the euro area.
REBALANCING AND REFORMS FOR GROWTH
For many euro-area member states, the introduction of the euro ushered in a new era of abundant capital due to the elimination of exchange rate risks. And standard economic reasoning does suggest that capital should flow from capital-rich to capital-poor economies, where returns should be higher.
However, the favorable financing conditions in the euro-area countries with previously higher interest rates stimulated their domestic demand. A procyclical real interest rate effect then ensued. Higher domestic demand led to above-average inflation rates in the respective countries. While nominal interest rates hardly differed across the euro area, real interest rates were below average in the countries concerned.
At the same time, higher demand caused wages to rise as well, which pushed the real exchange rate up and reduced price competitiveness. This in turn dampened exports. But the dampening effect on the tradable sector was not sufficient to moderate overall wages. In other words, the interest rate effect dominated the exchange rate effect. Consequently, worsening exports did not trigger the necessary adjustment, and current account deficits continued. As a result, the deficit countries built up ever-larger external imbalances.
Structural rigidities amplified this process. Labor market barriers that protected insiders and shut out outsiders impeded wage adjustments. In so doing, they worsened the shift from the tradable to the non-tradable sector. And product market regulations hampered competition, innovation, and, ultimately, productivity.
When the financial crisis erupted and investors' risk perception shifted, the financing of the...