In the previous post we examined why a fall in competitiveness will cause a depreciation in the exchange rate. But, what happens in the Euro where you can not depreciate against your main trading partners?
Suppose Greece experiences rising wages and rising prices. Greek goods become relatively uncompetitive in the Eurozone, therefore it will struggle to export and Greeks will buy more imports.
If they had a floating exchange rate, the Greek currency would depreciate and they would regain competitiveness through the exchange rate. But, in the Euro, they can’t do this.
Therefore, this puts increased pressure on the Greeks to reduce costs and inflation to regain competitiveness.
The advantage is that being in the Euro gives stronger incentives to retain competitiveness and keep inflation low.
The disadvantage is that if you struggle to keep inflation low the economy will suffer. Also you cannot depreciate the currency to improve the current account deficit.
For example Greece has a chronic balance of payments deficit. In 2008, the current account deficit was 13.5% of GDP. (source: Economist fact file Greece)
A similar problem is faced by Spain who has a current account deficit of 8% of GDP.
The problem is that it would be very difficult to force through wage cuts to improve competitiveness.
It’s a tough time for the Greek and Spanish economy.
No comments yet.