How to deal with Europe’s debt challenge

by Guntram B. Wolff on 17th February 2012

Growth in Europe is projected to be weak in 2012 and 2013. This is true for the aggregate but the outlook is much worse for many countries in the South. The south of the eurozone is, in fact, struggling with a twin challenge: high external debt and weak competitiveness. The indebtedness of Greece, Portugal, Spain and Ireland to abroad is around 100% of GDP and typically results form debt increases in the private sector. At the same time, price competitiveness is weak. Efforts to reduce indebtedness are slowing growth, but weak growth hinders the deleveraging: a catch-22 situation?

In such a situation, more exports are necessary as domestic growth is hampered by the deleveraging. To increase exports, competitiveness gains are inevitable and they can be achieved by downward wage adjustments. Wage adjustment will, however, lead to export success only after some time as business needs time to invest. In the short-run, the downward wage adjustment therefore aggravates the situation as wages fall but unemployment remains high. This is why the Troika in its first programme for Greece decided against cutting the 13th and 14th salary of Greek workers. It was feared that the same debt burden would need to be serviced with lower wages.

I consider this decision of the Troika as one of the biggest mistake done in the Greek programme. It ignores the fact that employment in the export sector can only be created with more competitiveness and more employment will increase income, even though wages are lower. An external debt overhang cannot be addressed by delaying the adjustment needed to pay back external debt. In fact, one of the striking features of today’s Greek economy is that despite all the fiscal austerity, Greece is living above its means: it is still running a current account deficit of 10% and exports are far below their 2007 level. The real economic adjustment has not happened to date and no export growth model has been developed.  

So what can be done to deal with the double challenge of external debt overhang and missing price competitiveness? Some have argued that delaying fiscal austerity would do the trick. The argument is that delaying the fiscal adjustment will reduce the downturn so that the debt burden measured in percent of output will not increase further. I doubt this will help much. Ultimately, growth needs to come from exports to allow for the deleveraging of external debt. Lower prices will help in that regard, more domestic demand will not.

Instead, I would identify broadly two main policy levers. The first is related to internal reform, the second relates to policies at eurozone level.

On the internal side, the fiscal consolidation should be made as little harmful to growth as possible by choosing the right mix of spending cuts and tax increases. Bad assets in the banking system resulting from the debt overhang in the household and corporate sector should be recognized with rigorous stress tests. The EFSF funds should be used for bank recapitalization and should be provided to governments at very low interest rates. Addressing these banking problems is central to making sure that credit is available for investment in export industries. Strong competition policy should be used to make sure that wage cuts lead to lower prices of export goods and do not just deliver larger corporate rents. Finally, a supply side agenda with the aim to improve education systems, innovation and business conditions is needed.

Besides domestic reforms, a forceful European policy response is needed. To be able to export, demand in the euro area as a whole needs to be appropriate. In current recessionary conditions, it is very difficult to grow exports. The responsibility of monetary policy in such a context is to avoid a recession and ensure price stability for the euro area as a whole. This means that once inflation rates in Southern Europe fall below 2%, inflation rates in particular in Germany will have to increase above 2%. Monetary policy should allow for such booming conditions in Germany and German policy making should not resist this adjustment. Moreover, fiscal policy instruments at a eurozone level may need to be developed if the recessionary environment deteriorates. A European wide investment strategy, for example in the area of energy transition, would be a potential candidate. Finally, structural funds should be used in a more targeted way to help grow exports in the South. Dealing with a debt overhang and competitiveness adjustment requires an effort by the eurozone as a whole.

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