The current gyrations of sentiment over government-bond spreads are diverting attention from the real issue – the Eurozone periphery needs a big realignment towards the tradable sector to reignite growth sustainably.
Spreads are a symptom
Improved global economic conditions and policy steps in the Eurozone have reassured markets since Italian and Spanish bond yields hit a peak last November. However, global conditions are volatile and the main policy steps taken, though necessary, are more palliative than cure.[i]
To start with, Greece’s debt remains unsustainable, and a second round of restructuring will be needed, this time comprising official debt. And the ECB’s long-term refinancing operation has shored up banks and supported government bond purchases, but they may backfire if, as is happening, risk aversion returns (Wyplosz 2012). Fiscal consolidation is unavoidable in the periphery, but at what speed? The question of whether its growth-depressing effects will allow deficit targets to be met remains wide open (see the austerity debate on Vox).
More important, the periphery’s fiscal mess is not at the root of the Eurozone crisis (Dadush et al. 2010). For example:
- Ireland’s debt-to-GDP ratio was almost halved between 1999 and 2007 (from 48% to 25%).
- Spain’s debt ratio also fell sharply (62% to 36%).
Nor are weak banking systems the cause of the crisis in the periphery. When the global financial crisis broke, the Italian and Portuguese banking systems were in much better shape than the French, German, or UK banking systems. Fiscal and banking problems, dangerous as they are, are a consequence of the crisis.
The deeper malady: Real-exchange-rate misalignments
In our view, the severe misalignment of real effective exchange rates in the Eurozone is at the root of the crisis.
The misalignment began in the mid-1990s as interest rates converged, and domestic-demand growth and inflation in the periphery were more rapid than in the core. Combined with cartelised product and labour markets, this led to erosion of competitiveness in the periphery – reflected in rising prices of non-tradables relative to exports and import substitutes and progressive reallocation of the periphery’s production factors toward the sheltered sector, most visibly construction. Measures and estimates of the misalignment vary, typically ranging between 15% to 30% (de Grauwe 2011).
- From 1997 to 2007, housing expenditure as a share of GDP cumulatively increased by 2.7 percentage points in the periphery (excluding Greece for which data is not available prior to 2000), compared to a 2.2 percentage point decline in Germany.
- Exports of goods and services as a share of GDP increased by almost 20 percentage points in Germany, while in the periphery they increased, on average, by less than 3 percentage points.
- Current-account deficits in the periphery deteriorated by nearly 8 percentage points of GDP, while surpluses in the core rose by 0.9 percentage points.[ii]
Financial markets mistakenly supported the periphery’s domestic demand–based growth model until it became obviously unsustainable. Recent analyses have shed light on the sudden stop in private capital flows to the periphery. Greece and Ireland, for example, experienced outflows equivalent to 40% and 70% of 2007 GDP, respectively, from mid-2008 to mid-2011 (Bornhurst and Mody 2012, Merler and Pisani-Ferry 2012a). Among the Eurozone’s periphery economies, current-account deficits did not narrow correspondingly because euros were made available through the intra-European payment system among central banks and rescue programs (Merler and Pisani-Ferry 2012b). By contrast, outside the Eurozone, countries such as Latvia (which did not devalue) saw a huge and immediate correction in their current account deficits.
Rooting out the disease
The external and internal imbalances in the periphery still necessitate a large real-exchange-rate adjustment. Given the post-2007 plunge in domestic demand, one would have expected to see price and unit-labour-cost containment and a shift toward exports by now. But over three years after the crisis erupted, progress has been remarkably limited (see table 1).
- With the exception of Ireland, there has been little decline in the real effective exchange rates in the periphery (in fact, over the last year, they appreciated!), and exports in the periphery have hardly budged as a share of GDP, increasing by less than in Germany and the Netherlands.
- Except in Italy, current-account deficits have come down, though largely due to demand contraction, and they remain significant (see Figure 1).
- The latest estimates available for Greece, from the third quarter of 2011, show a 3.7% current-account deficit and no export improvement despite an 18% decline in domestic demand since 2007.
Over the past year, the most notable change that has occurred is a further increase in the periphery’s unemployment and (except for Italy) the government debt-to-GDP ratio.
Table 1. Is the periphery rebalancing?
Figure 1. Current-account balance in the periphery
More demand compression and recession is coming, placing enormous strain on the periphery’s social fabric. The unemployment rate is already at around 24% in Spain, 21% in Greece, 15% in Portugal and Ireland, and 9.3% and rising fast in Italy.
With large fiscal contraction in store in the periphery over the next two years, banks deleveraging, and consumers and investors scared, there is no possibility of growth coming from domestic demand in the foreseeable future. Indeed, with structural reforms incomplete and slow to work, recession is the main instrument to engineer the internal devaluation. And in economies where both the private and public sector have become highly externally indebted, without internal devaluation a recovery of domestic demand will quickly run into borrowing constraints as the current account deficit widens.
Can the tradable sector come to the rescue?
This appears least likely in Greece because its import-competing and export sectors are small and mostly based on tourism. Portugal is a little better off, with a bigger export sector, but one that confronts low-wage competitors directly. Ireland, by contrast, has large high-tech exports, amounting to 100% of GDP, funded and operated by foreign multinationals. Ireland has a chance of reigniting growth, but may be hit again by large banking losses.
Spain has several competitive international firms and, unlike the other peripheral countries, has maintained its share of European exports over the past decade. But its export sector is small at roughly 26% of GDP, its unemployment is already extremely high, and it still requires an enormous fiscal and housing sector adjustment. Its capacity to steer through more austerity thus remains in question.
Italy has a more diversified export base, and though its public debt is bigger, its housing, fiscal and labour market imbalances are not nearly as large as Spain’s. However, the adjustment in Italy is very recent and there is no sign yet of a trade-led recovery.
Policy: What to do?
One can imagine a vastly different political context where a €2 trillion “firewall” is erected, or the ECB provides unlimited support to governments, or even one where debts are mutualised. However, while in a terrible emergency political resistance to any one or to a combination of these may be overcome, none of these measures would deal with the underlying competitiveness issue, and may instead delay its resolution.
In any event, at present, there seems to be little alternative but to accelerate the adjustment process in the periphery through, for example, tax changes that incentivise exports and discourage consumption and imports, and more far-reaching labour and product market reforms. A less ideological approach to policy would also allow for some demand expansion in the healthy core, higher Eurozone inflation, and a lower euro, all of which would ease adjustment in the periphery.
However, if all this and the fiscal cuts are not enough to restore competitiveness in the periphery (as has so far been the case), and unemployment keeps climbing, new approaches must be considered. Should failing countries be assisted in restructuring their debt and to leaving the Eurozone? The complexity of doing so is daunting (Baldwin 2012) and great collateral damage would ensue (Xafa 2012), but there would at least be a light at the end of the tunnel. The alternative—depression, chronic unemployment, deindustrialisation and depopulation of the afflicted countries—and even more concentration of European industry in its Northern regions, is not what anyone signed up for, or electorates will accept.
Baldwin, Richard (2012), “The EZ breakup contest: Take ignorance seriously”, VoxEU.org, 10 April.
Bornhurst, Fabian, and Ashoka Mody (2012), “TARGET Imbalances: Financing the Capital-Account Reversal in Europe”, VoxEU.org, 7 March.
Dadush, Uri et al. (2010), “Paradigm Lost: The Euro in Crisis”, Carnegie Endowment for International Peace.
Dadush, Uri, and Bennett Stancil (2011), “Is the euro rescue succeeding?” VoxEU.org, 6 February.
De Grauwe, Paul (2011), “The Governance of a Fragile Eurozone”, Centre for European Policy Studies, May.
European Commission (2012), “Interim Forecast”, Directorate-General for Economic and Financial Affairs, February.
Merler, Silvia, and Jean Pisani-Ferry (2012b), “Sudden Stops in the Eurozone”, VoxEU.org, 2 April.
Xafa, Miranda (2012), “Greece’s Exit from the Eurozone Would Be All Pain, No Gain”, VoxEU.org, 18 March.
Wyplosz, Charles (2012), “The ECB’s trillion euro bet”, VoxEU.org, 13 February.
[i] The Spanish government has openly expressed doubts about meeting fiscal targets. Italy is in a somewhat better position. Still, ten-year bond yields for both countries have recently ticked up to 5.8 and 5.5%, respectively—their highest levels since the ECB’s first long-term refinancing operation. The five-year credit default swap for Spain, moreover, is now 485 basis points, close to its record of 492 last November.
[ii] The core is defined here as Austria, Belgium, Germany, France, Finland, and the Netherlands; the periphery as Greece, Ireland, Italy, Portugal and Spain.