Is the euro rescue succeeding?

Uri Dadush, Bennett Stancil

06 February 2011

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The New Year has been kind to the Eurozone. The euro has strengthened and bond spreads between Germany and Europe’s troubled economies have narrowed. Evidence that countries are dealing adequately with the underlying causes of the crisis, however, remains scarce.

The fiscal problems in Greece, Ireland, Italy, Portugal, and Spain (the periphery) – which are the focus of efforts in national capitals and in Brussels – are only part of the problem. Until leaders deal with the core issues – the periphery’s lost competitiveness and misaligned economic structures – Europe’s disease will continue to fester.

The good news

Things are looking up on many fronts:

  • Economic recovery is slowly taking hold in the core of the Eurozone.
  • Economic ministers are negotiating an expanded and more flexible European Financial Stability Facility, expected to be unveiled at the European summit in late March or even sooner.
  • A raft of new budget-cutting measures are being implemented in Portugal and Spain,
  • Spain has also announced a reform of its savings banks, underscored their determination to avoid the humiliation and conditions that come with an EU-IMF bailout.

Financial markets are responding well to these moves.

  • Since 1 January, credit default swaps on the periphery countries have dropped by 25 to 150 basis points;
  • The euro has strengthened by 2% against the dollar,
  • European stock markets are up 6% more than other major indices, and
  • National bond auctions have been successful and the tightly priced inaugural “Euro-bond” issue was eight times oversubscribed.

But as is evident from the still-high spreads and stagnant growth in the periphery, there is still not yet a light at the end of the tunnel.

A drawn out affair

As many have argued from its outset (see Baldwin et al. 2010, Dadush et al. 2010), the Eurozone crisis was always going to be a long affair. Europeans have come a long way from the denial, confusion, and anger of a year ago; they have shown they understand the magnitude of the crisis and are willing to share in the pain of dealing with it. But their response is still too timid, and they remain excessively focused on fiscal matters.

The crisis is not “mainly fiscal”. At its outbreak, government debt levels in Spain and Ireland were well below those in Germany. In fact, since euro adoption, public debt levels had fallen in all periphery countries except Portugal.

Instead, the true root causes of the crisis involve misaligned economic structures and lost competitiveness. As is familiar by now, the interest rate decline and confidence surge in the periphery that accompanied the euro adoption created a wave of spending and borrowing that raised wages relative to productivity and promoted the growth of domestic sectors, such as construction, at the expense of manufacturing. While the boost in demand was a one-time event that is now being played in reverse, it lasted for a decade, long enough to entrench grave economic distortions.

Furthermore, a number of ongoing mechanisms made this structural misalignment worse.

  • The periphery’s rigid, less competitive product and labour markets and their weak capacity to innovate made it impossible for them to match the export prowess of a recently reunited Germany (Ireland, where business climate indicators are strong and labour markets are relatively flexible, was a partial exception).
  • European monetary policy became too loose for the periphery, fuelling a construction boom in Greece, Ireland, and Spain, and an unprecedented banking expansion in Ireland.

The misalignments are clearly seen in Table 1, particularly in figures showing huge divergences in unit labour costs and export shares between Germany and the others.

Table 1. Europe diverges

Change from 2000 to 2007
 
Real Domestic Demand
Unit Labour Costs
Current Account Balance
Exports
Debt
2009 debt level
 
Percent growth
Percent growth
Percent of GDP
Percent of GDP
Percent of GDP
Percent of GDP
Germany
1.8
-0.8
9.3
13.5
5.2
73.5
GIIPS Average
25.16
24.6
-3.8
-3.3
-7
85.2
 Greece
32.6
25.2
-6.7
-2.1
-7.9
115.2
 Ireland
43.4
27.3
-5
-17.7
-12.7
65.5
 Italy
9.3
21.5
-1.9
1.9
-5.7
115.8
 Portugal
6.8
-
0.8*
3.3
14.3
76.3
 Spain
33.7
24.4
-6
-2.1
-23.1
53.1
* Despite the improvement, Portugal's current account balance was a still-dismal -9% of GDP in 2007.
Sources: Eurostat, ECB, IMF.

The global financial crisis thus exposed the unsustainable nature of the periphery’s growth model and – by reflection – the precariousness of their fiscal situation. Unless a new and more balanced growth model is established, the euro disease will persist.

Assessing progress

In principle, an extended period of austerity (fiscal consolidation, increased household savings, corporate and bank deleveraging) could lower prices and wages in the periphery, thereby re-establishing competitiveness. But is this happening?

Certainly, there is no shortage of austerity. Since 2007, when economic activity in Europe peaked, domestic demand has fallen by an eye-popping 23% in Ireland, 11% in Greece, and 8% in Spain. It has also declined modestly in Italy (4%) and Portugal (2%), while growing by 2% in Germany.

Yet despite announced wage cuts and the euro’s decline (down nearly 6% in effective terms since the end of 2007), Ireland is the only periphery country to see its real effective exchange rate improve significantly. Spain has regained competitiveness modestly, but only at about the same pace as Germany, while the other three countries in the periphery have lost further ground compared with Germany. Moreover, while world trade is booming again, consensus forecasts for 2011 suggest the periphery countries will be stagnant or even shrink. Italy is projected to show 1% growth in 2011, as it did in 2010, but its GDP is still expected to be about 4% lower than its pre-crisis peak.

Figure 1. Real effective exchange rate

On this evidence, austerity appears to only redress the competitive and structural divergences at a snail’s pace. With the possible exception of Ireland, the periphery countries have no choice but to enact structural reforms to stimulate innovation and increase competition in product and labour markets. Absent these changes, the divergences between the periphery and core may not close, or may even widen again (European Commission 2010).

So far, each country has taken modest steps. Though not yet reflected in competitiveness indicators, Greece appears to be embarking on far-reaching structural reforms as part of its EU-IMF programme (IMF 2010). But across Europe these measures have been insufficient. This should not be too surprising. Reforms such as liberalising the markets for professional services attack powerful interest groups directly – and nearly always require the application of an external force.

At this stage, policymakers in Brussels are focused on fiscal consolidation and on how to finance this adjustment. The array of proposals brought forward to ease the financial burden on the periphery is truly impressive; they range from debt restructuring, to expanding the European Financial Stability Facility and allowing it to buy government bonds directly, to reducing the interest rate and extending the maturity of government loans, to issuing Euro-bonds to fund much of the Eurozone countries’ financing requirements.

While each of these proposals has merit, all fail to address the root causes of the crisis, and, if not carefully implemented, can ease pressure on politicians to act. Moreover, debt restructuring could easily trigger a big banking and governance crisis (Bini-Smaghi 2010).

A different tack

So what should be done differently?

  • First, leaders in the Eurozone must recognise that they are dealing with at least a five-year problem, and plan their response accordingly.

The periphery countries must show that they are achieving progress on competitiveness, export performance, and the composition of growth. These will prove to be even more important than meeting short-term fiscal targets.

  • Second, while enough financing should be available to the periphery to backstop the adjustment, the precise shape of the financing mechanisms is less important than conditions that maximise the incentives on politicians to act, including measures that discourage drawing on financing in the first place.

This is also a reason to envisage sovereign debt restructuring only as a last resort. Greece will very likely require such restructuring eventually, but – so long as its reforms are progressing at a rapid pace – the option of a “soft” renegotiation of its debts (longer maturities and lower interest rates) – and involving mainly public creditors and bond repurchases on the open market – should be preserved.

  • Third, the core countries must recognise that growing their wages and demand and allowing the euro to depreciate will both help them and greatly facilitate adjustment in the periphery.

Continued expansionary policy by the ECB is also needed. Though rescuing the euro while keeping European inflation slightly below 2% would be just perfect, the former, not the latter, is the main objective.

Conclusion

Adequate financing and fiscal soundness are necessary but not sufficient. Politically thorny reforms that restore international competitiveness are also crucial. Only when these broad conditions for growth have been re-established can the euro rescue be deemed a success.

References

Baldwin, Richard, Daniel Gros, and Luc (eds.) (2010), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.

Bini-Smaghi, Lorenzo (2010), “Europe cannot default its way back to health”, Financial Times, 16 December.

Dadush, Uri et al. (2010), “Paradigm Lost: The Euro in Crisis”, Carnegie Endowment for International Peace.

European Commission (2010), “Quarterly report on the euro area”, Directorate General for Economic and Financial Affairs, March.

IMF (2010), “Greece: Second Review Under the Stand-By Arrangement—Staff Report”, December.

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Topics:  EU policies Europe's nations and regions

Tags:  Italy, Spain, Ireland, Greece, Fiscal crisis, Eurozone crisis, Portugal

Senior Associate, Carnegie Endowment for International Peace; and Distinguished Visiting Fellow, OCP Policy Center

Bennett Stancil

Research Assistant, International Economics Program, Carnegie Endowment for International Peace

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