An overview of market-based adjustment in the euro area in the light of the crisis

The global and euro area debt crises have shown that the effect on individual economies of a common economic shock can be very different across the euro area. This has rekindled interest in the role of market-based adjustment processes in mitigating cyclical differences in the euro area. The objective of this special edition of the Quarterly Report on the Euro Area is to review the issue of shocks and adjustment in the light of the recent crisis. This overview chapter reviews the main findings of the report. It discusses the main features of the shocks that can have large asymmetric effects on individual Member States. The analysis distinguishes between the factors that leave an individual economy particularly exposed to shocks, and features of EMUís set up which may amplify the effects of certain shocks. This overview also summarises the main results of the three subsequent chapters which are devoted to the ërelative price mechanism, í the ëreal interest rate mechanismí and the role of balance sheets in adjustment processes. The ërelative price mechanismí has been at work both before and since the global financial crisis. Member States in comparatively weaker cyclical positions have benefited from falls in relative costs and prices which helps to buttress their cyclical positions. However, the mechanism has been slow to kick-in since the global financial crisis and its stabilising function has been hampered by frictions in labour and financial markets. The current low level of inflation in the euro area also tends to exacerbate the nominal downward rigidities documented by the empirical literature on the euro area. The report also shows that financial fragmentation has exacerbated the destabilising effect of the ëreal interest rate mechanismí and that balance sheet consolidation can substantially prolong adjustment processes. Policies can help mitigate risks of large asymmetric shocks in the euro area both by reducing Member States' exposure to shocks and by strengthening their adjustment capacity. The Banking Union, structural reforms and measures to address the debt legacy of the crisis all have a role to play. Action is needed in both debtor and creditor countries.