The persistence of euro-area imbalances

What’s at stake: Eurozone imbalances have long been considered a key factor in the build-up of the euro crisis. But the question of whether and how rebalancing is taking place between countries of the Eurozone has been overlooked amongst European policymakers as the narrative of the crisis has focused on fiscal issues and the flawed institutional design of the eurozone. After several years in the Lesser Depression, the currency bloc still appears to be afflicted with fundamental imbalances that are harbingers of slow growth and persistent unemployment.

Fighting the wrong crisis

Michael Pettis argues that 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 was the inevitable consequence of those capital flow imbalances.  Trade deficit nations have received capital inflows for many years from surplus nations as the automatic counterpart to their deficits.  If the surplus nations ever hope to get repaid – i.e. to reverse those capital flows – then it must be obvious that the trade imbalances must also reverse.

In its daily briefing, Eurointelligence notes that even S&P – the ratings agency that downgraded several countries of the eurozone in the past week – pointed in its assessment that the December summit failed to address the actual crisis. In the word of S&P, “the agreement is predicated on only a partial recognition of the source of the crisis: that the current financial turmoil stems primarily from fiscal profligacy at the periphery of the eurozone. In our view, however, the financial problems facing the eurozone are as much a consequence of rising external imbalances and divergences in competitiveness between the eurozone's core and the so-called periphery.”

Kemal Derviş argues that a reduction in Germany’s surplus may be more urgent than a reduction in China’s, since reducing Germany’s surplus will yield more immediate benefits for Europe, where the greatest risks to global recovery lie. Moreover, the Chinese renminbi is experiencing a fairly steep real appreciation, as inflation in China is rising much more rapidly than in the US or the eurozone. Indeed, the “German” euro is losing value, despite Germany’s large surplus, because it is also the currency of the southern European countries that are in so much trouble.

Taking stock of recent developments

The Real Time Brussels blog points that important data from Eurostat showing limited competitiveness gains by countries in the euro-zone periphery relative to Germany and other countries in the currency bloc’s core went largely unnoticed with the focus on the recent ECB’s move to provide long-term liquidity to banks. According to the data published last month, Greece has actually made progress: private-sector wages fell 5.4% in the third quarter from a year earlier and 12% since their peak in the first quarter of 2010. Euro-zone wages on average rose 2.7% since the third quarter of 2010. Ireland too has made some progress, with wages down 4.7% since their peak in the fourth quarter of 2009. But considering that wages rose nearly 60% since Ireland adopted the euro, they need to fall much more for the Irish economy to regain much of its lost competitiveness. Elsewhere, labor cost developments have been truly puzzling. Spanish wages were 3.4% higher in the third quarter than they were a year earlier. This despite terrible labor force conditions, with an unemployment rate topping 20%. Spanish wages rose faster than in the euro-zone on average and faster than in Germany (+3.1%). Spanish wages appear to be extraordinarily “downwardly rigid,” the term economists use to describe how wages in most labor markets rise easily but rarely fall. Portuguese wages rose about 1% over the past year. That’s less than the euro-zone average, but it also means that the adjustment will probably take many years, leaving Portugal with festering double-digit unemployment.

Paul Krugman argues – based on recent work by the Central Bank of Ireland – that the apparent success of Ireland in achieving internal devaluation might be a statistical illusion. How so? Well, Ireland is an economy that generates a lot of GDP — but not much GNP — out of capital-intensive, foreign-owned export sectors, such as pharma. And what has happened in the austerity era is that these sectors, which aren’t selling to the domestic market, have held up much better than labor-intensive sectors serving that domestic market. And this causes a spurious increase in labor productivity: if you lay off a construction worker but don’t lay off a pharma worker who basically watches over very expensive machines that produce a lot of output, it looks as if productivity has gone up, but in any individual sector nothing has happened.

Mickey Levy writes in VoxEU that disaggregating the competitiveness trends into wages and productivity shows that the bulk of the divergence between Germany and CA deficit countries within the eurozone stems from differing patterns of wage hikes. Certainly, from 2000-2008, Germany’s productivity rose faster than most other Eurozone nations. But official data shows that since 2000, including the recent period of deep recession and recovery, labor productivity gains in France, Spain, and even Portugal have kept pace with Germany. Italy has been the outlier, with no gains in productivity since 2000. The real story, therefore, is not that German workers are more productive, but that German agreed to wage restraints. A combination of factors led German labor unions to accept modest wage increases during 2000-2008. Very soft economic growth and rising unemployment during 2000-2005 raised fears of job layoffs. Prime Minister Schroeder’s “Agenda 2010” reforms reduced safety nets for the unemployed, encouraging people to accept lower-paying jobs. German businesses increased reliance on part-time workers and outsourced more production to Eastern Europe. Inflation was low, averaging about 1.5% during 2000-2008 (persistently below the Eurozone average of about 2.25%) and largely maintaining real purchasing power. Under these circumstances, the German labor unions worked closely with government and business leaders and accepted modest wage increases in exchange for job security.

Considering policy options beyond infernal devaluation in deficit countries and directly boosting spending in surplus countries

Matthew Higgins and Thomas Klitgaard of the New-York Fed argue that the difficulties the euro area faces adjusting to external imbalances raise the question whether new institutional arrangements should be considered to induce earlier and more automatic rebalancing. The authors refer to a recent article by Goodhart and Tsomocos (2010) who propose a tax on capital outflows within the euro area to act as a brake on the buildup of external imbalances and to ensure that the adjustment burden is shared among countries with surpluses and deficits.

Agnes Benassy-Quere and Benjamin Carton argue in TelosEU that the effects of introducing a social VAT – as proposed by French President Sarkozy – are very similar to that of a currency devaluation. Import prices rise following the increase in VAT, while the prices of domestic products remain flat provided that the decrease in labor costs is completely passed through. Although attractive, this measure is unlikely to prove sufficient to reduce imbalances, as it is hard to see how countries with a VAT rate already close to 20% could increase that rate by more than 3 percentage points. Portugal, for example, considered this option but eventually gave it up as it fell short of the price adjustment needed to restore competitiveness. If foreign exporters price to market, they will furthermore likely change the price of their products in order to maintain their market shares and as such cancel the intended change in relative prices.

Lack of RER adjustment, nominal rigidity and the level of potential output

Paul Krugman argues that recent events in Europe have given us a dramatic demonstration of the reality of nominal wage stickiness. What you see here is that despite crushing unemployment, wages in Ireland and Latvia have come down only slightly — but Iceland, by letting its currency devalue, achieved a quick 30 percent fall in wages relative to the euro zone. International macroeconomists know that the behavior of real exchange rates — exchange rates adjusted for relative inflation — is a prime piece of evidence for price stickiness. Not only do real rates move very closely with nominal rates, but the behavior of real rates changes dramatically when you move from floating to fixed rates or vice versa.

A number of authors have, however, argued that rather than being a demonstration of the reality of nominal stickiness, the lack of wage and price adjustments might be the sign that potential output has decreased a lot in the crisis.

Target 2 forever

Martin Wolf argues that Professor Sinn raised a genuine question even if he exaggerated some of the problems that it created for managing money and credit in Germany itself. We see central bank financing of balance of payments imbalances, via the lender of last resort function of the national central banks. But the financing of imbalances is what allows them to exist. The question is whether it is legitimate for the European System of Central Banks to finance external imbalances in this indirect way.