The travails of EMU imbalances
What’s at stake: Worrying divergences are emerging between the bloc’s healthiest and weakest economies. France and Germany have already emerged from the recession. Yet on the periphery, the hangover from more than five years of a credit-infused boom shows little sign of diminishing. What began with worries about the solvency of Greece in the face of high deficits, fake budget figures and low growth has quickly become the most severe test of the 16-nation euro zone in its 11-year history as the PIIGS turmoil reflects a wider crisis of imbalances in the 16-nation eurozone: the sharp divergence of national economies that share a common currency without significant fiscal coordination and high mobility of labour.
No longer a taboo subject
The Economist’s Charlemagne reports that DER Spiegel has caused a stir in Brussels by reprinting bits of an unusually gloomy internal report from the European Commission on the euro zone. People have focussed on the report's finding that differing competitiveness among euro zone countries is "a cause of serious concern for the euro area as a whole." Ralph Atkins notes that the ECB views over diverging performances inside the EMU have recently changed. Previously, the ECB tended to argue that such differences did not pose any greater challenge than, say, divergences between states in the US. But a recent speech, Jürgen Stark, executive board member and head of the economics department, argued that unwinding such imbalances “is urgent”.
Edward Hugh writes that the EU’s own analysis of the problems in the Eurozone is coming nearer and nearer to that of both the IMF and the credit rating agencies. We are moving beyond short term fiscal deficit issues, and immediate liquidity issues, towards problems like competitiveness, and what was previously a taboo subject – the issue of Eurozone imbalances. These were, in fact, supposed to disappear with the passage of time, so it was expected that they would have diminished rather than increased. In that sense there is now an implicit admission that the institutional environment in which the common currency has been operated was severely deficient and badly needs to be improved.
Sylvester Eijffinger and Edin Mujagic document that in 1999 the difference between the euro-zone countries with the lowest and highest inflation rate was two percentage points. By the end of 2009, the difference had almost tripled, to 5.9 percentage points. As for economic growth, the difference between Ireland and Portugal in the first half of the decade was 4.8 percentage points. By 2009, it had increased to six percentage points. Moreover, the productivity difference increased from 25 index points in 1999 to 66.2 in 2008; the difference in unit labour costs went from 5.4 percentage points to 31.8; and the difference in the unemployment rate rose from 10.1 percentage points to 15.4. The implications of these increasing differences could be severe. Increasing tensions between the euro countries on economic policy are likely, as are growing rifts within the ECB governing council in the coming years.
E.U. debt crises highlight bloc's structural weakness
Nouriel Roubini and Arnab Das argue that failure to take the tough decisions necessary on Greece would draw attention to an uncomfortable historical truth: that no currency union has survived without a fiscal and political union. The contrast between the eurozone and the US would become ever starker. Many US states are also in fiscal crisis, but local problems can be solved at a federal level. Should transfers fail to do the trick, a chapter of the bankruptcy code is devoted to sub-federal governments. The eurozone lacks such burden-sharing mechanisms. Ideally, formal rules for fiscal burden-sharing should be developed to give teeth to no-bailout clauses, such as debt restructuring mechanisms for eurozone sovereigns.
Paul Krugman argues that it’s important to realise that the crisis in the largest of the PIIGS has nothing to do with fiscal irresponsibility. On the eve of the crisis, Spain was running a budget surplus; its debts were low relative to GDP. Spain is an object lesson in the problems of having monetary union without fiscal and labour market integration. It has nothing to do with a spendthrift government; what’s happening to Spain reflects the inherent problems with the euro, which now more than ever looks like a monetary union too far. In an interview, Krugman notes that Spain is very much in the same situation as gold-standard countries in the 1930s; in some ways worse, because it lacks the option of using trade policy as a substitute for devaluation.
Marek Belka, director of the IMF’s European Department, says that the future success of the Euro now depends on establishing new institutions and rules to create a stronger and more coordinated Europe. Underlying the divergence in economic performance were a variety of factors operating in varying combinations: rapid growth in property prices, insufficient supervision of financial sectors, and long-standing structural weaknesses. Changes on the margin are, in any case, not likely to influence the major underlying source of the problem: differences in country policies and structures.
What should current account deficit countries do?
Philip Lane has a new paper that analyses the role of fiscal policy both in the emergence and the unwinding of external imbalances. His analysis indicates that fiscal policy interventions can be helpful in facilitating the external adjustment process. This is especially important for member countries of a monetary union, since fiscal policy can help to engineer the type of shifts in the real exchange rate that can be accomplished via nominal currency movements for countries outside a monetary union.
Daniel Gros argues that a fiscal adjustment that is not reflected in an increase in the national savings rate would simply transfer the problem from the government to the private sector. A cut in the fiscal deficit would simply result in more private debt. Banks would see non-performing loans accumulate, and in the end they would have to be bailed out by the government. Adjustment requires belt-tightening by the entire economy. To set Greece and Portugal on a sustainable economic path requires an increase in savings; put simply, it needs a cut in consumption of about 10 per cent of GDP. Europe's stability pact is flawed because it concentrates only on one sector (government) rather than the entire country's resource balance.
A Fistful of Euros notes that the extent so far of the internal devaluation process depends on the time period used for analysis. Using Q3-2007 as the beginning of the economic crisis suggests that Greece and Spain have not corrected relative to Germany as a benchmark. However, if we look entirely at the world in a post-Lehmann context the picture is different with Greece and Spain having observed excess deflation relative to Germany to the tune of -1.7% and -4.5% respectively for unit labour costs and -5.4% and -1.7% respectively for the PPI.
What should current account surplus countries do?
Tony Barber argues that it will be as necessary to raise demand in Germany and other surplus countries as to hold down wages and root out corruption in Greece to overcome the eurozone’s crisis. For sure, Greece and Portugal need to improve their competitiveness, but they would also benefit from stronger foreign demand for their products and services, especially in Germany. Wolfgang Munchau makes the same point and argues that the place to handle this co-ordination is the Eurogroup, which now constitutes an official European Union institution under the Lisbon treaty. Jean-Claude Juncker, the prime minister of Luxembourg and chairman of the Eurogroup, should make imbalances the defining issue of his agenda and propose binding policies.
Martin Wolf says that what people do not seem to understand is that peripheral European countries cannot escape from their trap because they are caught in a game of competitive deflation with Germany (and the Netherlands). So long as the eurozone has an external balance (roughly) and Germany has a vast surplus, the rest of the zone MUST be running aggregate deficits. This then means that either the private sector runs deficits (spends more than its income) or the public sector does. If the latter is pushed towards balance, by eurozone pressure, GDP must contract enough to force the private sector finally back into deficit and so towards bankruptcy. Ultimately, the only way out of the trap is for nominal wages and costs in peripheral Europe to fall so much that it forces Europe into depression.
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