A year ago, the euro zone's most important challenge was anemic economic growth. But last year turned out to be a good year for growth in the EU, as surprising strength in exports sparked unexpected increases in domestic demand.
Germany, the euro zone's biggest economy, had an especially dramatic turnaround, with annual GDP up by 2.7 percent in 2006, the highest rate since 2000.
Not only has German resurgence raised overall growth in the EU, it has also made growth less evenly balanced throughout the euro zone. This is because Germany is growing faster than the other large economies using the euro, France and Italy.
Germany accomplished this feat by dramatically changing the structure of its corporate sector. From 2001 to 2005, it had a "silent revolution."
While observers and commentators focused on the economy's slow overall growth, behind the scenes, largely unnoticed, important changes were taking place. Without fanfare, German workers accepted longer hours without increases in pay. This allowed Germany to improve its competitive position in world markets compared with the other large euro-zone economies, where there were no productivity revolutions, silent or otherwise.
It took some time for the change to show results. But by last year, both German exports and GDP were growing faster than in France and Italy.
Before the introduction of the euro, the reform gap between Germany and its larger neighbors would have been no problem. The currencies of the reform laggards would have depreciated against that of Germany, and there might have been a supportive cut in interest rates as well.
This is no longer possible. Superior German economic performance has bid up the euro and interest rates to levels that, while comfortable for the Germans, put pressure on others. The appropriate level of the euro for the Germans is too high for the French and Italians. The right interest rate for the French and Italians is too low for the Germans.
For reform laggards like France, Italy and Portugal, currency union with an increasingly competitive Germany is forcing an unwelcome choice between revving up their own reforms and permanent stagnation.
This is no easy choice. Even with political will, revving up the reform process is a difficult task. Indeed, it took a motivated Germany four to five years to do it. But the prospect of permanent stagnation for countries like France, Italy, and Portugal is unacceptable. Chronic stagnation is too high a price.
Naturally, politicians are reluctant to face up to choices between the unacceptable, ie permanent stagnation; the unthinkable, ie leaving the euro; and the hard-to-do, ie reform. So they are taking refuge in fantasy.
In France, for example, all current presidential candidates hold out the unrealistic prospect of staying in the currency union but watering down the independence of the European Central Bank (ECB) and its price stability mandate, increasing "consultation" between governments and the ECB, and manipulating the euro to France's advantage.
This is pure escapism. Approval of fundamental changes in the currency union must be agreed by all members, and so will not be forthcoming. Nor will ECB President Jean-Claude Trichet be intimidated by French pressure to pursue a softer monetary policy.
Trichet is a tough guy with a long history of standing up to the French politicians. They couldn't make him bend when, as governor, he successfully defended the independence of the Bank of France, and they won't make him bend now.
At this month's meeting of the ECB's Governing Council, for example, Trichet virtually announced that European interest rates would be increased in March just before the April French elections. The ECB President made it clear he would do his duty whatever the political pressure.
The defining factor in Trichet's sense of duty is the Maastricht Treaty, which clearly states the prime objective of Europe's central bank to be the promotion of price stability. Some in France -- and not just the left -- want to change this. One idea making the rounds is for the European Parliament to define the ECB's objectives, on the basis that it is democratically elected.
This high-handed attempt to highjack the ECB and make it a servant of the European Parliament would mean chronically low European interest rates and a depreciated euro. France would be off the reform hook, of course, but at the expense of Germany, which would face unwanted inflationary pressures.
This proposal illustrates how the reform gap, and the unbalanced growth that results from it, can debilitate the European fabric by setting one partner against the other. To protect European cohesion as well as improve their own economic situation, France and Italy must reform at a faster pace than Germany rather than waiting for it to slow down.
The hard-to-do is preferable to the unacceptable and the unthinkable. Still, there is little indication that the two reform laggards are up to the challenge.
Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University. Copyright: Project Syndicate
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