In the above graphic note that France has closely tracked the agreed EU inflation target of 2%, while Germany violated the agreement, largely by repressing wage increases (and hence Unit Labor Costs).
Heiner Flassbeck has been studying the impact of Germany’s wage deflation policy for at least six years. E.g., from 2006 he wrote:
The European Monetary Union can only function if nominal wage increases in all member countries are in line with the inflation target set by the monetary authorities. Given the close correlation of unit labor cost growth (nominal wage growth minus productivity growth) and inflation, the implicit rule of the monetary union asks for real wage growth in each member state following strictly national productivity progress and for unit labor costs not exceeding and not undershooting a 2 percent growth path in each member state.
Violations of this rule will either lead to inflation or deflation in the union as a whole or to deviations of national real exchange rates and national levels of competitiveness bearing grave long-run consequences for the appreciating countries. This kind of aberration started with the beginning of the currency union in 1999–with Germany, due to its deflationary wage policy, being the main culprit. Without fundamental changes in wage policies throughout Europe, a deflation or a transfer union, comparable to the German transfer union after unification, is an imminent danger.
A much more detailed investigation is in Intereconomics vol 46, 2011, Flassbeck and Spieker, The Euro – a Story of Misunderstanding.
From the very beginning of the European Monetary Union the crucial institutions, the European Commission and the European Central Bank, led by mainstream economic thinking, were not up to their task of controlling the core of the system effectively. A huge gap in competitiveness among the member states has arisen due to German wage-dumping policy on the one hand and, on the other, wage growth in Southern Europe which is above the growth of productivity plus the infl ation target of 2%. A European-wide coordination of wage policy is the only promising way to close this gap. However, as wages and competitiveness are not high on the agenda of the politicians responsible and their advisers, time to save the euro is running out.
For another perspective on the same core problem, see Michael Pettis “If no trade reversal now, then when?“. Prof. Pettis puts it this way:
Europe’s underlying problem is not budget deficits or even unsustainable debt. These are mainly symptoms. The real problem with Europe is the huge divergence in costs between the core and the periphery – in the past decade costs between Germany and some of the peripheral countries have diverged by anywhere from 20% to 40%. This divergence has made the latter uncompetitive and has resulted in the massive trade imbalances within Europe.
Trade imbalances, of course, are the obverse of capital imbalances, and the surge in debt in peripheral Europe in the past decade – debt owed ultimately to Germany and the other core countries – was the inevitable consequence of those capital flow imbalances. While European policymakers alternatively sweat and shiver over fiscal deficits, surging government debt, and collapsing banks, there is almost no prospect of their resolving the European crisis until they address the divergence in costs. Of course if they don’t resolve this problem, the problem will be resolved for them in the form of a break-up of the euro.
The best resolution, and the one Keynes urged without success on the US in the 1920s and 1930s, is that Germany take steps to reverse its trade surplus. It could boost disposable household income and household consumption by cutting income and consumption taxes, and as German household income grows relative to the country’s total production, the national savings rate would automatically drop and the trade surplus contract and eventually become a deficit. Or Germany could engineer a massive increase in infrastructure spending.
I highly recommend a careful read of both Pettis and Flassbeck.