On Thursday, two seemingly isolated events in Europe focused our attention on the Continent. First, the European Central Bank (ECB) decided to raise interest rates by a quarter of a percent, signaling a "return to normal standards," according to Ewald Nowotny, member of the ECB Governing Council and governor of the Austrian National Bank. Nowotny indicated that the move was more symbolic than it was practical, although it did signal the ECB's intention to start dealing with Europe's rising inflation. Second, the Italian interior minister accused the French government of being "hostile" for not offering help as Rome deals with an influx of migrants fleeing chaos in Libya and post-revolutionary Tunisia.
The two events are in fact very much related. At the heart of the European Union project is the eurozone, the common currency bloc that buttresses Europe's common market. While not all EU members have adopted the euro, 17 have and another eight are contractually obligated to eventually do so -- only Denmark and the United Kingdom have negotiated opt-outs. Despite the union's many faults, the common currency binds Europe's major economies together by removing the ability to competitively devalue against other euro members, their main trading partners. Common currency is also supposed to bring about convergence across the disparate societies, economies and geographies. The ongoing sovereign debt crisis can attest to the fact that the perceived convergence over the past decade has been, by and large, an illusion, but it has also spurred Europeans to reinforce rules and enforcement mechanisms, with the aim of actually realizing convergence over the next decade.
"The ongoing sovereign debt crisis can attest to the fact that the perceived convergence over the past decade has been, by and large, an illusion."
Thursday's events are equally detrimental to the convergence that the EU project requires. First, raising interest rates to tame inflation might make sense for the eurozone, as a whole, and particularly for Germany, whose economy is thundering on all pistons. But for the rest of the eurozone, particularly the smaller peripheral economies dealing with over-indebtedness, austerity measures and high unemployment (to name a few), the move can only further complicate an already complicated situation. It is true that eurozone inflation is rising (on average) due in part to higher energy prices, but higher energy prices have reduced people's disposable income, and such increases can actually be deflationary for other sectors of an economy, notwithstanding the fact that energy is technically an input in every good. Given that a number of peripheral countries are already exhibiting deflationary trends, a one-size-fits-all monetary policy threatens to reawaken and exacerbate macroeconomic instability in the eurozone's most troubled economies. This counter-intuitive potential side-effect is combined with the fact that higher rates will also weigh on peripheral households with variable rate mortgages tied to the ECB policy rate.
In a deflationary environment, the broad-based increase in prices that normally erodes debt is reversed, increasing its burden in real terms. By increasing rates and reinforcing deflationary trends where they exist, the ECB only increases expenses on peripheral Europe. So when the ECB decides to raise interest rates for the sake of cooling the German economy, it also puts peripheral Europe under the knife, making convergence that much more difficult to achieve.
One important factor that catalyzes convergence is the free movement of labor. When people are able to move across an economic space, workers from a low-wage area can pursue jobs where wages are rising. This movement helps to stabilize wages across both regions, as it reduces excess labor in the low wage area and reduces the deficit of labor in the higher wage area. For this reason, the most effective currency unions allow and encourage a free labor movement (along with free capital movement, synchronized business cycles and a federal entity capable of taxing and spending). The "U.S. dollar zone" is a great example. The economy of California is much different than that of Texas or New York, and all are different from Kansas, but they're all able to use the U.S. dollar -- and U.S. citizens can pack up the car, get on a freeway and set up shop in a new state for whatever reason they wish. The U.S. federal government also has the ability to tax and spend: The spending aspect is key because it enables the government to help offset asymmetric shocks to America's economy when free labor and capital mobility can't get the job done in time, or at all.
Europe has always had a problem in this particular pillar of its currency union. The union allows free movement of labor in legal terms. However, when compared to the United States, it is far more difficult for a resident of Galicia, where unemployment is more than 20 percent due to a collapse of the construction industry, to hitch a trailer to his car and move to Baden-Wuerttemberg, where unemployment is around 4 percent. There are also cultural and linguistic barriers unlike anything Americans face, although the Europeans have at least removed administrative barriers to cross-country employment and have removed borders between the states, as any visitor or resident of Europe can attest to. These may not encourage perfect labor mobility, but they are important symbolic and technical steps toward an eventual convergence.
This is why the second event of the day is troubling for Europe. The Libyan unrest and the Tunisia revolution have flooded Italian shores with around 20,000 migrants. Italy wants its EU neighbors to pick up the slack and take in some migrants; but, in all honesty, nobody in Europe is eager to take on more Muslim migrants, least of all neighboring France. In response, Italy has decided to issue the migrants temporary resident permits so that they can cross Europe's unregulated borders. It is Rome's way of forcing its neighbors to pick up the slack. The French countered with its Interior Ministry ordering border officials to make sure that migrants from third countries crossing its borders are checked for a number of conditions, in addition to the possession of residence permits, before being allowed entry. However, there are no such border officials on the Franco-Italian border. Therefore, either France intends to restaff vacated border posts and impose checks on all travelers, or Paris is bluffing.
Either way, the lack of fundamental support for truly open European borders is illustrated by the disunity over the issue of 20,000 migrants. France is legally correct: A temporary permanent residency is not sufficient for third nationals to set up in another EU member state (they also need proof of financial means, for example). But Italy is right in principle: Why should it shoulder the majority of negative effects of the North African fiasco merely because of geography, especially when Paris has been so vociferous about intervening in Libya and escalating EU member state involvement in the crisis?
Both events illustrate how superficial integration of Europe truly is. The German-dominated ECB is pursuing a German-dominated monetary policy. France has no sympathy for its neighbor, with whom it supposedly shares a common labor, currency and economic space. At the first sign of crisis, national interests overcome post-national aspirations.
Copyright 2011 STRATFOR.