Serious intraregional divergences in competitiveness and the related buildup of regional imbalances have been the root cause of the crisis in the euro zone. The Maastricht treaty of 1992, which created the European Union and led to the creation of a single European currency (the euro), established criteria for EU member states that included the following conditions: Inflation rates below 1.5 percent, budget deficits not to exceed 3 percent of GDP, and public debt not to exceed 60 percent of GDP Since wages are an important determinant of prices, wage rates corrected for productivity growth (unit labor costs) were expected to remain aligned to keep the union in a sustainable position.
While Germany restrained wages, other member countries such as Greece and Portugal failed to limit the continued rise in wages and inflation, which affected their overall competitiveness. Trade imbalances built up as low-inflation countries began to gain in competitiveness over those with high wage and price inflation. Trade deficits in crisis-affected countries were financed by debt as banks in surplus countries such as Germany lent to borrowers and spenders in deficit countries. Borrowed funds were used to finance consumption and speculation (e.g., to build houses) and not to improve productivity or competitiveness.
When the investors who bought the bonds by lending to these countries realized that these countries were unable to repay the loans, they became nervous and started to sell off the bonds. Government bonds that were considered risky were subject to speculative attack, and their risk premiums rose dramatically. This rendered insolvent commercial banks whose balance sheets were loaded with these bonds. The banking crisis morphed into a sovereign debt crisis. Banks began to demand higher interest rates to lend to weaker countries. Rising borrowing costs for weaker countries and trouble for banks that loaned money to these countries constitute the root causes of the crisis.
In essence, all new initiatives continue to follow the old blueprint. Measures are mainly focused on strengthening the so-called Stability and Growth Pact and on aligning policies with the latest version of the EU’s long-standing structural reform agenda—the Europe 2020 strategy. Europe continues to ignore the vital issues of domestic demand management and proper policy coordination for internal balance, including the need for upward adjustment of wages and prices in surplus countries.
Source: Seyoum Belay (2014), Export-import theory, practices, and procedures, Routledge; 3rd edition.