RaboResearch - Economic Research

Eurozone: Closing the gap through fiscal transfers?


  • Southern member states have been struck disproportionally hard by the COVID-crisis but have little fiscal or monetary leeway. Transfers from north to south could be an option
  • Competitiveness has diverged strongly between northern and southern Europe. This can partially be explained by domestic policies and membership of the EMU
  • Economic convergence is a prerequisite for a stable Eurozone in the long term, but the economic reform needed to move towards an optimum currency area may be hard to realise
  • In the short term it might be more rewarding to investigate the possibilities of narrowing the gap in competitiveness
  • The best way forward is probably a mix of conditional fiscal transfers, economic reforms in southern Europe and relative wage increases in northern Europe

Transfers to close the gap?

The pandemic has struck the Spanish and Italian economy harder than core countries such as the Netherlands and Germany. This all comes on top of the already substantial gap in real GDP per capita and productivity, higher unemployment rates and more public indebtedness.

The policy options for dealing with this domestically are limited however. Monetary policy is set in Frankfurt for the EMU as a whole and therefore cannot be used to solve regional issues. And since Spain and Italy do not control the exchange rate of the Euro, they cannot depreciate their currency to jumpstart their economies. Moreover, their public finances are so highly compromised that there is little fiscal space to restart the economy.

In this Special, we reflect on one potential remedy, namely fiscal transfers from North to South. We investigate whether transfers are viable, what form they should take and how and if they should be complemented by additional policies. It is in the interest of other EMU members that the recovery in Spain and Italy does not lag behind the rest. For starters, a lackluster economic recovery in Italy and Spain will result in lower demand for export products in other member states. More importantly, it would make the rising public debt in those countries pile increasingly hard to bear. This may again trigger market concerns about the indebtedness of peripheral economies. Given the relatively fragile institutional setup with sovereign Member States, this could trigger concerns about the livelihood of the common currency in its current form as well. Finally, the effectiveness of the single monetary policy is inhibited when one group experiences a speedy recovery while the other does not.

In order to evaluate if and in which form fiscal transfers could work, we first have to dive deeper into how the divergence inside the EMU has come about and thus what problems need solving. In particular, we attempt to describe how and to what extent competitiveness inside the euro area has diverged. It is important to stress that competitiveness is not just about cheap labor and attractive pricing, but also about innovative, high quality products.

A measure for competitiveness

In order to assess whether countries have diverged in terms of competitiveness, we first need a metric. A frequently used measure of competitiveness is the Real Effective Exchange Rate (REER). This metric bundles three factors that influence competitiveness: foreign exchange rates, unit labor cost and the mix of trade partners (see Box 1 below). However, it does not capture the underlying drivers of competitiveness, such as wages, education or innovation[1]. The absolute value of this metric cannot be directly interpreted, but changes in its value point towards an improvement or deterioration of a country’s competitiveness vis-a-vis its trading partners.

Box 1: The Real Effective Exchange Rate

The metric we use to compare competitiveness of countries, the REER, has three important features. First, the REER is basically a weighted exchange rate, that is, the local currency is valued versus a basket of other currencies. Second, the individual exchange rates are weighed by trade volume. Kenya is a less important trade partner for France than the United Sates. The Kenyan shilling therefore is given a lower weighting in the French REER than the US dollar. Third, the REER accounts for the difference in unit labor costs (ULC) – which refers to the labor costs incurred to produce one unit of output. An increase in ULC, makes it harder to set a competitive price for your product.

A country, or a monetary union like EMU, can influence its REER through three channels. The first channel, which has an immediate effect, is via a direct appreciation or depreciation of the nominal exchange rate (i.e. a headline rate such as EUR/USD) by the central bank. Countries have often depreciated their currencies in order to give their exporting businesses a competitive edge. By lowering the nominal exchange rate, they make it cheaper for other countries to buy their exporting goods. If this depreciation is not followed up by structural change, the depreciation is usually followed by higher domestic inflation, which after some time effectively undoes the positive effect of a depreciation on demand for domestic goods.

The second channel is to shift trade weights or start to compete against other countries. However, this channel is not as fast as a nominal exchange rate change and is hard to steer. Countries can try to move trade by means of trade missions, import tariffs or via trade deals, but these methods often have political implications[2]. The third channel is unit labor costs. This channel takes time as well. Since nominal wages exhibit downward rigidity, it is hard to simply lower wages to increase competitiveness. Boosting labor productivity through structural investments or better education is another option, but again this cannot be achieved overnight.

Has competitiveness diverged inside the EMU?

The larger an area gets, the more likely it is to be heterogeneous economically. The EMU is a good example. The divergence between individual member states is clearly visible when we look at the REERs of individual EMU members (Figure 1). Italy in particular has seen a tremendous increase in its REER and thus a decrease in its competitiveness. Germany and the Netherlands have experienced the opposite. The Spanish REER paints a mixed picture. Whilst Spain’s competitiveness decreased strongly up until the global financial crisis (GFC), it has improved quickly afterwards.

Figure 1: Real Effective Exchange Rates have diverged in the Eurozone since introduction of the euro
Figure 1: Real Effective Exchange Rates have diverged in the Eurozone since introduction of the euroNote: A higher REER indicates lower competitiveness
Source: Macrobond, IMF

What domestic factors explain the differences in these four countries?

Interest rates converged from the introduction of the EMU (Figure 2). If we look first at Spain, we see that private sector debt then ballooned (Figure 3). A considerable part of the funds went into Spain’s overly large construction sector and fueled a housing bubble, which eventually burst (Figure 4). During the boom phase, wages in the non-tradable sector rose rapidly and spilled over into the tradable sector as well. Investments in property do not lift productivity. Spain therefore lost ground in terms of competitiveness. The housing boom did bring rapid demand-driven economic growth and may have led to complacency and a lower focus on addressing structural weaknesses or increasing potential growth. When the GFC hit in 2008 and the domestic-demand fueled boom in Spain turned into a bust, budget deficits started to swell: unemployment rose, tax revenues fell and local government stakes in banks also left them with real estate exposure. Spain’s low public debt ratio quickly rose and subsequent European demands for fiscal prudence exacerbated rising unemployment (Figure 5).

Figure 2: Yields on government debt were practically equal pre-GFC
Figure 2: Yields on government debt were practically equal pre-GFCNote: This effect can be seen for all maturities Source: Macrobond
Figure 3: Credit to the private sector (% GDP) ballooned in Spain pre-GFC
Figure 3: Credit to the private sector (% GDP) ballooned in Spain pre-GFCSource: Macrobond, IMF

After the GFC, Spain showed that it was capable of implementing economic reforms and restructuring its economy more efficiently. This resulted in a remarkable recovery in productivity levels and competitiveness. This recovery can partially be attributed to the fact that Spain did not introduce a furloughing scheme during the GFC and partly to the high incidence of temporary contracts[3]. Consequently, Spain’s labor market shifted away from large, severely hit and unproductive sectors, such as construction. Moreover, job losses forced Spanish companies to look for markets elsewhere since domestic demand had crumbled. Companies in the tradeable sector are generally more productive than companies focused solely on the domestic market. In combination with acceptance of wage stagnation by the labor unions, this helped to improve Spain’s competitiveness post-GFC. Unfortunately, there has been little progress on further economic reform in the past few years.

Figure 4: Spain had a large construction sector
Figure 4: Spain had a large construction sectorSource: Macrobond, Eurostat
Figure 5: Spain’s low public debt ratio rose fast
Figure 5: Spain’s low public debt ratio rose fastSource: Macrobond, Eurostat

In Italy, the story was different. Private sector indebtedness did not rise as rapidly as in other Southern European economies, and has been at relatively low levels from an EMU perspective. Italy did have a large public sector debt dating from the pre-EMU era. But on the back of lower financing costs associated with entering the EMU, the public debt ratio declined until 2004 and stayed roughly the same until the start of the GFC. Only in 2008 and 2009 did Italy record a small deficit on its primary balance.

However, as other peripheral countries started to struggle and broader fears mounted over the continuation of the euro, Italy was sucked into the euro crisis. Rightly or wrongly, Italy was identified as a possible next weak link given its large public debt stock, low historical economic growth and the poor credibility of the Berlusconi government. Italy’s problems were magnified by a weak banking sector, which is intertwined with the government through large holdings of national sovereign debt. As a result financial markets viewed Italian debt as relatively risky, financing costs started to rise and the debt stock rose further.

Which brings us to Italy’s main vulnerability. The country has been stuck in an era of stagnating productivity growth and low economic growth. This makes the public debt stock a heavy burden on the annual budget and thus limits fiscal space for reform (Figure 6). Transfers from the wealthy, productive north towards the poor, unproductive, southern part of Italy may have contributed heavily to the public debt stock. The differences between northern and southern Italy have also made governing and reforming the country much harder. Especially since a number of political parties explicitly prioritize the north over the south.

In comparison to Spain, Italy has made relatively little progress since the GFC when it comes to reforming its economy. The Italian domestic economy weathered the GFC storm better because, unlike Spain, it had no real estate bubble and did deploy a furlough scheme for redundant employees. The downside was Italy saw no real structural shift in labor markets from less to more productive sectors. Consequently, overall productivity remains low even though the Italian economy does have plenty of potential for reform. The OECD estimated that Italian GDP growth could increase by as much as a full percentage point per year if Italy were to effectively implement a list of reforms.

Figure 6: Italy’s productivity growth has been stagnant
Figure 6: Italy’s productivity growth has been stagnantNote: Data is presented using an index. In level terms, Spain’s labor productivity is still significantly lower (see figure 7) Source: ECB
Figure 7: Productivity levels are lower in southern Europe
Figure 7: Productivity levels are lower in southern EuropeSource: ECB

The Netherlands and Germany, on the other hand, have seen steady productivity growth throughout the EMU era. Moreover, neither country experienced a domestic demand boom fueled by cheap foreign credit (which has the potential to erode competitiveness via higher wage than productivity growth). In fact, current account balances in Germany and the Netherlands have moved in the opposite direction compared to other countries in the periphery, such as Spain. Some of the credit that fueled spending booms in the periphery probably came from Germany and the Netherlands. Admittedly, the Netherlands also has rather high private sector indebtedness and has also experienced its fair share of housing market problems. The combination of a surge in mortgage debt and limited fiscal stimulus from the government played a significant role in explaining its slower economic recovery compared to Germany. However, both the housing boom and the bust were less intense in the Netherlands than in Spain. The Dutch construction sector is also smaller and the increase in labor costs in the Netherlands was backed up by productivity growth (Figure 8).

In addition, the Netherlands and Germany have seen a period of wage moderation. Labor cost growth was particularly low in Germany during the first decade of the EMU (Figure 9)[4]. For the period 2000 to 2010 the median, after-tax real income grew only by 1.4% in total. The Netherlands applied similar tactics, but somewhat earlier than Germany. After the crisis in the late 70s (marked by high inflation, high government budget deficits and low economic growth), economic policy making changed drastically in the Netherlands. The labor unions and businesses came to an agreement (known as the Wassenaar-agreement) and wage growth was moderated to prevent any large layoffs, especially during the 1980s. Wage moderation became the standard and consequently, Dutch competitiveness improved significantly, the current account improved and the economy once again flourished. Internationally, this change of fortunes was dubbed the Dutch miracle. Dutch policy makers, employers’ associations and trade unions all agreed on the importance of a moderate wage development in the 1980s and 1990s. However in more recent years, there has been a call for an increase in wages.

Figure 8: House prices have moved extremely in Spain
Figure 8: House prices have moved extremely in SpainSource: Macrobond, OECD
Figure 9: Nominal labor costs relative to other EU members decreased in the first 10 year for Germany
Figure 9: Nominal labor costs relative to other EU members decreased in the first 10 year for GermanySource: Macrobond, AMECO

The EMU is not an optimum currency area

Diverging competitiveness need not necessarily be a problem. Take regional differences within countries, for example. Much economic activity is concentrated in North Rhine Westphalia and Bavaria for Germany, in Lombardy for Italy and in Catalonia for Spain. This reflects the fact that productivity levels and competitiveness vary greatly between regions. Within countries this is not an issue however, since there are fiscal transfers, there is (more) mobility of capital and labor and the regions are likely to have a relatively similar business cycle. Regions meeting these conditions, can soften idiosyncratic shocks to a sub region by fiscal transfers or by rebalancing capital and labor.

Regions such as those mentioned above are referred to as ‘Optimum Currency Areas’ (OCA), a concept introduced by Nobel prize winner Robert Mundell. However, the EMU, does not satisfy these conditions yet. Even though there is free movement of goods, services, capital and labor in the Schengen area, differences in national legislation (on bankruptcies or labor protection for example) restrict truly free mobility of capital and labor. Additionally, there is no fiscal framework to soften idiosyncratic blows. Consequently, any shocks with asymmetric consequences (such as the European debt crisis) are not spread evenly across the region as a whole; they remain concentrated in a country, resulting in strongly diverging economies.

In particular, the lack of fiscal integration has proved problematic. When the Euro was introduced financial markets viewed countries as equally risky: the assumption was that risks would be shared across the currency union, which meant that Greece could profit from Germany’s higher credit rating. The abrupt lowering of financing costs fueled a domestic demand boom in some peripheral countries. When the GFC unfolded and bust followed boom, markets were quick to realize that the EMU was not actually the optimal currency area they had thought it would be, in the sense that risk-sharing mechanisms were not as strong as previously believed. Consequently, peripheral spreads rose and the debt burden grew for indebted countries.

After the dust settled, we saw peripheral economies with strained public finances, higher financing costs, higher unemployment rates and significantly lower GDP per capita levels. On top of that, Spain and Italy lagged behind Germany and the Netherlands when it comes to competitiveness[5].

Why fiscal transfers be a solution

It is clear that the establishment of a currency union that does not meet the necessary conditions may cause divergence between its members instead of the economic convergence that was envisaged at the start of the EMU. At the same time, this divergence increases the probability of asymmetric shocks, which the EMU cannot efficiently address because it lacks appropriate shock absorbers. Moreover, weaker member states lack the fiscal space to weather the storm on their own. Intra-Eurozone relations and the single monetary policy will therefore remain under pressure each time weaker member states receive a large asymmetric blow, such as the one being experienced right now.

In order to move to a sustainable EMU, it would be best to reshape it as an Optimum Currency Area. However, this will take time and has proven hard given cultural and political differences. In the meantime, the EU would do best to mitigate the divergence, which decreases the probability of asymmetric shocks and boosts the resilience of weaker member states in the face of these shocks.

It is in this context that we now explore the possibility of fiscal transfers.

Convergence in unit labor costs is the ‘simplest’ instrument

Since countries have a common currency, but a diverging REER, the competitiveness gap cannot be addressed via the nominal exchange rate change. Any adjustments will therefore have to go through either the channel of trading partners or, more importantly, via the channel of unit labor costs. The majority of trade for Eurozone countries is with other Eurozone countries: distance is the most important determinant and there are obvious advantages to having a single market. We therefore focus on narrowing the gap in unit labor costs.

The gap in unit labor costs can in fact be narrow by fiscal transfers, provided that funds are not made available unconditionally. Funds should not be used to finance private and public consumption or social spending, but instead aim to increase productivity and competitiveness in Spain and most notably Italy. Additional to narrowing the gap in unit labor costs, higher economic growth through an increase in productivity and competitiveness, also eases the burden of public and private debt.

It is important to note that this economic growth should not lead to too much upward pressure on real wages, which would undo competitiveness gains. This pressure could be relatively minor as there currently is a lot of slack in Southern European labor markets. Admittedly, the relatively large skill mismatches may lead to shortages of qualified labor, still inducing risk for wage raises in concentrated parts of the economy, but addressing these skill mismatches could be a condition for receiving funds.

Will the northern member states agree?

It may prove hard to get the northern member states on board. Some of the southern states have not proved to be very efficient reformers or do not have a track record of allocating funds effectively. There is often a political will (although there is scepticism towards northern interference in national matters) for economic reform, but well-intended bills often crash on implementation. Additionally, the many layers of government and bureaucracy in Italy for example, are extra hurdles. And even if these countries have changed, or were able to adequately implement economic reforms in the first place, public opinion in northern Europe is sceptical at best. Transfers could therefore prove to be a hard sell in northern Europe.

And what’s to say that southern governments will not give into the demands for wage increases in the public sector which might spill over to the private sector, once the economic outlook starts to improve (thereby undoing any competiveness gains)? In any case, it will not be an easy sell for southern Europe either, as people in the South may be reluctant to accept wage stagnation after all the hardships experienced in recent years.

Can things be done the other way round?

Northern European states may also prefer to do things the other way round: that is, increasing their unit labor cost through a rise in wages. Instead of transferring funds to the south, the Netherlands and Germany could increase fiscal spending in order to increase public sector wages, which should spill over into the private sector as well. This would be much easier to sell to the electorate than fiscal transfers to other countries. Of course, the downside is that higher unit labor cost would decrease the competitiveness of export-oriented firms in northern member states. That said, German and Dutch production are relatively more reliant on capital goods than on labor, and the quality of the goods is often a more important driver of demand than price. Moreover, if consumers have more money in their pockets, the domestic economy should be able to flourish more.

While this method would reduce the competitiveness gap between North and South, it does not solve the larger structural weaknesses in the South. Although some of the higher wages in the North will turn into demand for Southern European products, there is no incentive for the southern countries to reform. Nor do they have the financial space to achieve reforms on their own. As such, the benefits from economic convergence, such as more effective monetary policy and easier decision-making at the European level, are not likely to be realized with this approach.


The asymmetric impact of the current COVID-19 outbreak across the Eurozone has again laid bare the shortcomings of the euro area. The Eurozone is not an optimum currency area in the sense of the classical definition of the Nobel prize winner Robert Mundell. As such, weaker member states are less resilient when confronted with the asymmetric consequences from a shock.

It would be best to reshape the EMU towards an optimum currency area, but this will take time. In the meantime, it would be best to mitigate the divergence, which boosts the resilience of weaker member states in the face of asymmetric shocks.

Fiscal transfers could, in theory, be the ideal solution (given the right conditions) to converge the economic fate of member states. However, it will be hard to get the Northern member states on board given the daunting task that lies ahead and the track record of some of the Southern member states with respect to reform. Northern member states may prefer to address the gap in competitiveness by increasing wages at home as it will be easier to sell to the electorate. Even though this approach looks easier, it does not offer a solution to the structural weakness of southern Europe.

We conclude that a mix of both possible solutions is the best way forward. This means that Northern Europe should focus more on developing its domestic economy and stimulate wage growth. At the same time, at least some funds should be transferred to the South under strict conditions that they address structural weaknesses there. This will probably require some form of policy coordination from European authorities.

A first step towards transfers has already been taken with the recovery fund, which, in essence is a transfer from north to south since it will be co-financed and the latter were hit harder. Member states have to put economic reform on the agenda to qualify for the grants (which is one of the arguments that we have stated above as well). It is nowhere near enough to achieve the economic convergence we envisage in this piece. And whether this is the first step towards more economic convergence remains to be seen.


[1] Even though the REER has some shortcomings, the conclusions we draw based on the REER are supported by competitiveness indices. The REER is a quantitative tool to explain the divergence within the EMU.

[2] Moreover, trade deals and import tariffs are set at the European level.

[3] When the economy recovers and the number of people with temporary contracts in relatively unproductive sectors rises again, the gains in average productivity could fall again.

[4] Even though this was not an active policy set by the government, a possible explanation is the decrease of employees represented by labor unions, which play an essential role in the wage setting process.

[5] This is not only visible in the REER measure we have used, but can also be grasped from various competitiveness index rankings.

Erik-Jan van Harn
RaboResearch Global Economics & Markets Rabobank KEO
Michiel van der Veen
RaboResearch Netherlands, Economics and Sustainability Rabobank KEO

naar boven