Exchange rates, catch up, and lagging behind in Europe since 1870

"It is well known that a country by manipulating the value of its currency can push up its competitiveness in international markets. This notwithstanding, it is much overlooked how exchange rates have influenced economic growth and convergence of income among nations in a longer perspective. In particular, among countries involved in market integration, one could presume that those on a lower level of income should have a higher inflation. The higher inflation, with a concomitant rise of wages, should then erode their competitiveness and counteract convergence. A somehow flexible exchange rate might compensate for this loss and contribute to the catch-up of countries still behind. The theoretical point of departure in this paper is that countries with lower levels of income have also lower levels of prices and wages than richer countries. When poorer countries catch-up with the richer, they necessarily have higher inflation and wage growth. Unless these asymmetries in prices and wages are compensated for by nominal exchange rates, the poorer countries will decline in relative competitiveness. Since we deal with trends over longer periods and not temporary shocks, it is not necessary to determine when a currency is undervalued or overvalued. Instead, the focus can be on the relative change of exchange rates and their long term effects. The paper examines how exchange rate movements have interacted with economic growth and price changes across European countries since 1870. In that purpose, we look at how exchange rates have exposed countries to each other through foreign trade. The contribution of the paper is that effective exchange rates are brought into a long-term analysis of (mostly west-) European growth and convergence. The next section of the paper shortly reviews the treatment of exchange rates and growth in the literature. Section three introduces the history of exchange rates across seventeen European countries, and how the effective exchange rates are estimated. Section four explores the pattern of long-term convergence and divergence of GDP per capita in Western Europe. Section five discusses the interaction between growth, prices, and exchange rates over 1870-2010 divided in five different sub-periods. Section six concludes with a discussion of further implications."