Uri Dadush on The Euro Crisis and The Coming Euro Collapse- Pardigm Lost

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The Euro Crisis

From The Report by Uri Dadush:

SUMMARY

The Euro crisis, which strikes at the heart of the world’s largest trading block, contains only two of the three fateful elements—problematic sovereign debt in Greece and other vulnerable countries, and fragile European banks, which hold a large part of that debt. Monetary policy in the Euro area and in industrialized countries more generally, remains expansionary and, if anything, the crisis pushes back the time when tightening can occur safely. As a result of the problems in Europe, the world economy has become even more exposed to the three mega-vulnerabilities…

The Deeper Causes of the Euro Crisis

While ballooning public debt may be the clearest manifestation of the Euro crisis, its roots go much deeper—to the secular loss of competitiveness that has been associated with euro adoption in countries including Greece, Ireland, Italy, Portugal, and Spain (GIIPS).

The sequence of events that led to the secular loss of competitiveness is depressingly similar among the GIIPS countries:  The adoption of the euro was accompanied by a large fall in interest rates and a surge in confdence as institutions and incomes expected to converge to those of Europe’s northern core economies. Domestic demand surged, bidding up the price of non-tradables relative to tradables and of wages relative to productivity. Growth accelerated, driven by domestic services, construction, and an expanding government, while exports stagnated as a share of GDP, and imports and the current account deficit soared amid abundant foreign capital. The result was that indebtedness—public, private, or both—surged. Meanwhile, following reunifcation, Germany was undergoing a historic transformation to become the world’s largest exporter, and all of Europe’s northern economies reaped the benefts of the expanded market and decreased competition ofered by the GIIPS. But the growth model in the GIIPS was inherently flawed: eventually, the domestic demand bubble burst. Now, governments must shrink, and high costs preempt any efforts to resort to export markets for growth. Countries are stuck in a low growth equilibrium—and potential domestic battles over the limited resources will only accelerate the onset of crisis.
This basic story is of the Euro area periphery, but the details vary within each country. For example, Italy and Portugal saw growth peak very early on, while Greece, Ireland, and Spain enjoyed decade-long booms followed by busts during the global crisis. The single monetary policy of the euro was too loose for the countries who enjoyed the biggest boom and accentuated their infation and competitiveness loss, while it was too tight for larger economies like Germany, depressing domestic demand there and widening its unit labor cost advantage vis-à-vis the GIIPS.

Effects on Other Countries

 A similar and even more virulent strain of the euro disease has already hit countries that are not part of the Euro area but that pegged their currencies to the euro many years ago, beginning with Latvia, Estonia, and Lithuania. Other recent EU joiners, such as Hungary and Romania, retain flexible exchange rates, but are constrained by large foreign currency debts in their ability to devalue. As a
consequence, they too suffer from the euro disease.
The rest of the world will feel the effects of the Euro crisis via six important channels: first, the crisis will lower growth in Europe, a market toward which about a quarter of world exports are destined. Second, it will lead to further euro depreciation, sharply reducing profits from exports to Europe while also increasing competition from the continent. Third, by keeping policy rates low in Europe and potentially other industrialized countries as well, the crisis may encourage capital surges into emerging markets. Fourth, the crisis will add greatly to the volatility of financial markets and will lead to bouts of risk-aversion. Fifth, and potentially most important, the crisis could deal a mortal blow to many fragile financial institutions. Sixth, a failure to contain the crisis will raise the alarm on sovereign debt in other industrial countries and, inevitably, in any exposed emerging market.

The Making of a Crisis
 
 1. Confidence in the prospects for growth and stability of the economies of Greece, Ireland, Italy, Portugal, and Spain (GIIPS) surged when the euro was introduced, causing their interest rates to decline to those of Europe’s more stable members.
 
2. Improved confidence and lower interest rates drove up domestic demand in the GIIPS and investors and consumers were emboldened to increase spending and run up debts, often owed abroad as foreign capital flowed in.
 
 3. Growth accelerated and the prices of domestic activities (i.e., those least exposed to international competition, such as housing) rose relative to the price of exportable or importable products, attracting investment into the less productive non-tradable sectors and away from exports and industries competing with imports.


4. Meanwhile, exports rose sharply as a share of GDP in Germany, the Netherlands, and other historically stable countries in the European core. Growing demand in the GIIPS enabled these
core countries to increase exports. The adoption of a common currency whose value was based
on broader European competitiveness trends that made it lower than the deutschmark or guilder
might have been, made their exported goods more affordable.

5. The domestic demand boom in the GIIPS induced rapid wage growth that outpaced productivity, increasing unit labor costs and eroding external competitiveness further. This trend was reinforced by especially rigid labor markets in most of the GIIPS. The emergence of China, as well as currency depreciation and rapid labor productivity growth in the export sectors of the United States and Japan, added to the competitiveness problems of the GIIPS


6. The single European monetary policy was too loose for the rapidly growing GIIPS (Spain, Greece, and Ireland) and too tight for Germany, whose domestic demand and wages grew very slowly
compared to the European average. This reinforced the loss of competitiveness in the GIIPS.

 7. Lower borrowing costs and the expansion of domestic demand boosted tax revenues in the GIIPS. Instead of recognizing this as temporary revenue and saving the windfall gains for when growth slowed, GIIPS governments signifcantly increased spending. Blatant fiscal mismanagement added to the problems in Greece


8. The financial crisis in 2008 brought an abrupt end to the post-euro growth model in the GIIPS. As they plunged into recession and tax revenues collapsed, government spending was revealed to be unsustainable and their loss of competitiveness dimmed hopes of turning to foreign demand for recovery. The GIIPS are left with high public and private debts and weak long-term growth prospects, unless they make difcult adjustments to cut deficits and restore competitiveness.

The Euro Boom

 In February 1992, European leaders signed the treaty on European Union (also known as the Maastricht treaty), laying the foundation for monetary union and adoption of the euro. Te agreement eventually bound the currencies and monetary policy of the signatories—which included all the GIIPS except Greece—to that of Germany, Europe’s largest and most stable economy, and to those of other successful economies in northern Europe.
Expecting that the stability and wealth of Europe’s northern members (EUN)—Austria, Belgium, France, Germany, and the Netherlands—would difuse throughout its periphery and that the EUN’s stronger institutional and economic frameworks would prevail over those of the GIIPS, confidence in the GIIPS surged. After averaging infation levels and public borrowing costs from 1980 to 1990 that are comparable to those of Ghana today, the GIIPS (excluding Greece) saw their infation and interest rates converge with those of the EUN during the 1990s. Long-term government bond yield spreads of the GIIPS vis-à-vis the EUN, which indicate the perceived risk of lending to the GIIPS instead of the EUN, fell from 550 basis points in 1980–1990 to just 10 in 1999.
 
 

 
Widening External Imbalances
 
Low interest rates and improved confidence fueled a domestic demand surge partly financed by foreign lending. The GIIPS, especially Greece, Ireland, and Spain, saw an increase in domestic spending accompanied by deteriorating current account balances and rising private debt.


The demand surge drove up both prices and wages, particularly in service and non-tradable sectors, leading the price of non-tradables to rise relative to tradables and attracting even more investment in the former. From 1997 to 2007, the price of services in the GIIPS rose by an average annual rate of 1.5 percentage points


more than that of goods, compared to a diference of 0.5 percentage points in the EUN. The GIIPS’ economies realigned away from manufacturing and industrial sectors and toward services and housing construction: 4 percentage points of GDP  shifted from industry to financial services, real estate, and business from 1997 to 2007, compared to a shift of 2 percentage points in the EUN. Over the same period, per capita employee compensation rose by an average annual rate of 5.9 percent in the GIIPS, considerably faster than the EUN’s average of 3.2 percent. These increases were not matched by improvements in productivity, particularly in the GIIPS, where labor productivity per employee grew by 1.3 percent per year, compared to 1.2 percent annual growth in the EUN.

As a result, unit labor costs rose by 32 percent in the GIIPS from 1997 to 2007, compared to a 12 percent increase in the EUN. Underpinning these trends was a remarkable transformation of the German economy following the country’s unifcation, making it the world’s largest exporter.

The result was a dramatic decline in competitiveness in the GIIPS against other advanced countries. The loss was particularly severe relative to countries outside of the Euro area, which saw labor costs increase only moderately and whose labor costs in euros benefited from the euro’s nearly 50 percent appreciation against the dollar from 2000 to 2007.

Expanding Government

 In all of the GIIPS, lower borrowing costs and the expansion of domestic demand boosted tax revenues and tempted governments to expand spending as well. Rather than recognize that the revenue increases from the boom were windfall gains that should be saved, the GIIPS accelerated government spending. From 1997 to 2007, public spending per person rose by an average of 76 percent and government’s contribution to GDP rose by 3.5 percentage points. In the EUN, average per capita spending increased by 34 percent and the government’s contribution to GDP stayed constant.


In Ireland and Spain, the temporary revenue surge more than compensated for these spending increases—both countries averaged government surpluses from 2000 to 2007, despite increases that were greater than those in nearly all other Euro area countries. Nevertheless, signs o budget weakness emerged. For example, Ireland’s structural deficit, a figure that ignores the cyclical changes in revenues and expenditures, worsened from 1 percent of GDP in 2000 to over 8
percent in 2007.


Other GIIPS showed more evidence of fiscal deterioration. As growth in Portugal and Italy slowed at the end of the 1990s, their deficits gradually increased, rising by approximately 1.3 percentage points of GDP by 2007. In Greece, blatant mismanagement added to the troubles—despite strong growth,
Greek deficits averaged 5 percent of GDP from 2000 to 2007.

GERMANY: EUROPE’S PRIDE OR EUROPE’S PROBLEM?

Greece, Ireland, Italy, Portugal, and Spain (GIIPS) have become increasingly uncompetitive since adopting the euro. But competitiveness is relative, raising an important question: how did Germany, Europe’s largest and most competitive economy, fare under the euro? Te answer begins with Germany’s unifcation ten years prior, which was followed by massive investments designed to modernize the East’s economy and integrate it with Germany’s industrial heartland. Though this process remains incomplete even today, it has prompted far-reaching structural reforms and contributed to exceptional wage moderation following the immediate post-unifcation surge. Additionally, the introduction of the euro consolidated Germany’s unit labor cost advantage vis-à-vis its Euro area partners. Exports surged and domestic demand growth fell behind that of the GIIPS, widening bilateral trade surpluses. Germany, now poised to derive the greatest gains from the euro’s crisis-triggered decline, should boost its domestic demand to compensate for the defationary measures taken by the GIIPS.

Current Account Balnce of Germany

Post-Reunifcation Reforms

Immediately after reunifcation in late 1990, Germany experienced a significant loss of competitiveness. Unit labor costs (ULC), which measure increases in wages relative to productivity, rose significantly. Wages in the East rapidly began to converge to those in the West even as productivity in the former remained substantially lower. As a result, unit labor costs grew by 17.6 percent from 1990 to 1995, compared with an average of 11.5 percent in the rest of what would become the Euro area.

Reunifcation also brought a demand boom that emphasized services over export sectors. As the West made transfers to the East in order to boost living standards, domestic demand expanded by nearly 7 percent of GDP from 1990 to 1992. This fueled services, which grew 7 percent on average each year from 1990 to 1995, compared to only 3 percent on average from 1996 to 2008. On the other hand, exports fell as a share of GDP from 1991 to 1993.
The economy’s historic restructuring and the high unit labor costs in the East hindered the country’s competitiveness, and drove unemployment up from 4.2 percent in 1991 to 8.2 percent by 1994. Export-oriented industries were particularly hard hit in terms of employment.
Germany responded to these challenges with structural reforms, including wage moderation and industry restructuring. Government spending on employee compensation fell by 1 percent of GDP from 1993 to 2000 and the private sector soon followed the public sector’s lead. Rising unemployment, as well as the ability of corporations to turn to cheaper sources of labor in other countries, encouraged domestic labor to soften demands in collective bargaining. As a result, unit labor costs actually fell 3.4 percent in industry from 1995 to 2000 and stayed almost stagnant in services, rising only 1.8 percent over the same period.
As a result of these changes, Germany saw its export performance improve and rise in signifcance. From 1993 to 2000, the share of exports in its GDP rose by more than 10 percentage points, from 22 percent to 33 percent. Despite its exports losing 3.5 percent of world share from 1990 to 2000, Germany outperformed advanced economies as a whole, whose share fell by 6.3 percent, over that period.

 Euro Adoption and the Export Boom

Germany’s exports benefited further from the adoption of the euro, which eventually became cheaper than the deutschmark might have been, given that it reflects Europe’s—and not only Germany’s—competitiveness trends. For example, the European Commission estimated that the euro was about 10–12 percent undervalued for Germany in the first quarter of 2009. The euro also increased external demand, including from the GIIPS.


Since adopting the euro, Germany has seen its exports regain world share, rising 0.5 percentage points from 2000 to 2009—a remarkable performance compared with the 11.6 percent contraction in the share of advanced countries over that period. Over the same period, exports have gained an additional 14 percent of GDP share in Germany, bringing the total gain from 1993 to 2008 to a remarkable 25 percentage points. In a nutshell, while the GIIPS became more inward-focused and driven by domestic activities, Germany became the world’s largest exporter.

WHY GREECE HAS TO RESTRUCTURE ITS DEBT






Prior to the establishment of the euro, Greece was among the worst economic performers of eventual Euro area members. Annual infation was one of the highest in the region; the Greek government paid the highest borrowing premium; and GDP growth was the slowest in Europe.


The adoption of the euro appeared to solve many of these deficiencies. Inflation fell from an average of 18 percent from 1980–1995 to just above 3


percent from 2000–2007. Over the same time periods, long-term government bond yield spreads vis-à-vis the German bund fell from 1100 basis points to less than 40. As Greece stabilized, it quickly became an attractive destination for foreign capital. Greece’s net foreign asset position, which measures the assets Greece holds abroad minus Greek assets held by foreigners, plummeted, falling from approximately -5 percent of GDP in 1995 to around -100 percent of GDP in 2007. Awash with cheap capital, domestic demand surged and the current account balance deteriorated from -3.7 percent of GDP in 1997 to -14.4 percent in 2008.
Domestic demand growth drove up prices in Greece relative to that of the Euro area, increasing domestic labor costs and eroding Greek competitiveness. Since 1997, consumer prices have risen by 47 percent in Greece, compared to an increase of only 27 percent in the Euro area; since 2000, per capita employee compensation has grown by over 80 percent in Greece compared to an increase of 23 percent in the Euro area. The resulting loss of competitiveness has been substantial: the IMF estimates that Greece’s real effective exchange rate is overvalued by 20–30 percent.


Competitiveness was hurt further by a shift away from manufacturing sectors in favor of the expansion of service and non-tradable sectors. Though not as large as the shift in other troubled European economies, manufacturing as a share of GDP fell by 2.5 percentage points from 1997 to 2007 from a low initial level, while construction’s share grew by 2 percentage points. Over the same period, the price of services increased faster than that of goods by an average of 1.3 percentage points, compared to a difference of 0.6 percentage points in the Euro area, encouraging further misalignment toward services.

These imbalances were not without (temporary) benefits. After averaging annual GDP growth of 1.1 percent from 1980 through 1997—the slowest in eventual Euro area countries—Greece’s economy expanded at an average rate of 4.1 percent over the next ten years, the fourth fastest rate in the Euro area. Per capita


GDP rose from 39 percent of that of Germany in 1995 to 71 percent in 2008. As tax revenues rose, the government rapidly expanded spending, especially in social transfers and public sector wages. From 1997 to 2008, Greece increased government spending per capita by 140 percent, compared to 40 percent in the Euro area. Over that period, social transfer spending rose from 13.9 percent of GDP to 18.9 percent, while the aggregate Euro area decreased such spending from 17.1 percent to 16.1 percent; Greek public sector per capita employee


compensation grew by 112 percent, compared to 38 percent in the Euro area. Reflecting the economy’s rapid growth, public sector deficits remained within what appeared to be reasonable bounds—averaging 5 percent of GDP from 2000 to 2007. Te picture changed markedly with the financial crisis and when markets realized Greece’s chronic failure to report accurate statistics. GDP expanded by only 2 percent in 2008 and contracted by 2 percent in 2009, pushing down tax revenues and driving up the restated deficit to 7.7 percent in 2008 and 13.6 in 2009.
With debt ballooning from 96 percent of GDP in 2007 to 115 percent in 2009—and the IMF projecting it to reach nearly 150 percent by 2012 even under the assumption of draconian fiscal measures—Greece’s borrowing costs skyrocketed. Worries mounted that Greece would not be able to repay its loans and that the crisis would quickly infect other troubled European nations. EU and


IMF leaders attempted to reassure markets with pledges of support to Greece; though initial efforts failed, later attempts, including a $145 billion support package, appears to have stabilized the situation, as it effectively covers the government’s borrowing requirement over at least the next two years.

 A DIRE WARNING FROM LATVIA AND ARGENTINA

Greece has been profligate and fiscally irresponsible. Still, the contrasting experiences of Argentina and Latvia in dealing with excessive spending and currency overvaluation—problems that now plague Greece—hold a warning for Europe: leaving the Euro area and defaulting—while almost unthinkable now—could become the best of very bad options for Greece, though it would have disastrous implications for both the European Union (EU) and the world. The EU must support Greece with all available means to prevent this from happening.



Inflation has been higher in Greece than in its northern Euro area neighbors for years, and wage increases in excess of productivity have impaired Greece’s ability to compete. As the table below shows, this problem is shared to different degrees by Ireland, Italy, Portugal, and Spain. Together, the affected countries represented 35 percent of the Euro area’s GDP in 2009 and constitute an economy over 30 percent larger than that of Germany.

Common features of currency overvaluation include an inability to grow without creating excessive current account deficits, rising debt burdens, and a gradual loss of investor confidence. There are only two ways to address the problem. The first is to devalue. For countries in the Euro area, this would require the radical step of abandoning the euro and returning to a national currency, leading to default as debt burdens soar relative to incomes. The other course of action is austerity and structural adjustment—reducing government spending, cutting wages, and undertaking reforms that raise productivity.


Examination of two polar cases of resolving overvaluation—Argentina, which was forced to break out of its currency board in January 2002 and devalue, and Latvia, which had to resort to IMF help in December 2008, has decided to tough it out and maintain its peg to the euro—suggests that the output losses associated with the latter can be even higher than those associated with devaluation and default.

In the three years prior to the onset of each country’s respective crisis, GDP in that country grew rapidly: 5.8 percent per year in Argentina and 10.9 percent per year in Latvia. Meanwhile, the real effective exchange rate appreciated by 12 percent in Argentina and by 24 percent in Latvia; the current account deficit exceeded 20 percent of GDP in Latvia in 2006 and 2007, and nearly 5 percent in Argentina in 1998—its highest level since before 1980.

Though Argentina paid a heavy price for devaluing and defaulting, its competitiveness was quickly restored and a rapid recovery—helped by favorable global conditions—ensued. Exports grew by 15 percent in 2003 and 17 percent in 2004, while GDP grew 8.8 percent in 2003 and 9.0 percent in 2004, regaining its pre-crisis peak within about ten quarters.

In contrast, though Latvia’s current account balance has swung to surplus, this has come on the back of demand containment rather than export growth: since the end of 2007, imports have fallen 41 percent compared to a 14 percent decline in exports. Latvia remains mired in recession, with the IMF forecasting that GDP will contract by 4 percent in 2010, followed by anemic growth of 1.5 percent in 2011. In addition to its large outstanding private debt, it now has a large foreign public debt burden to repay to the IMF and the EU.


Greece’s vulnerabilities have been building for years, and are in some respects as or more pronounced than those of Argentina and Latvia. From 2002 to 2007, domestic demand grew by an average of 4.2 percent, compared to growth of 1.8 percent in the Euro area. Foreign borrowing helped to finance this relatively rapid growth, and higher inflation in Greece resulted in a 17 percent appreciation of the real effective exchange rate over the past four years, less than various estimates for Argentina and Latvia. The current account deficit increased from 5.8 percent of GDP in 2004 to 14.4 percent in 2008, much larger than Argentina’s increase but smaller than Latvia’s. Greece’s public debt has reached an estimated 112 percent of GDP, almost double Argentina’s debt of 63 percent of GDP prior to devaluation, and about six times larger than Latvia’s pre-crisis level.

IRELAND: FROM BUBBLE TO BROKE

The Celtic Tiger

Well before the euro’s introduction in the late 1990s, Ireland was prospering. From 1990 to 1995, GDP was growing significantly faster than in other GIIPS, and inflation and borrowing costs were not only below that of the other GIIPS, they were close to German levels.


Additionally, Ireland’s governance and business climate indicators2 were among the world’s strongest. Labor markets were flexible and the education system was one of the best in Europe.

 A Path to Crisis

Whereas in other GIIPS, the euro added confidence where there previously was none, in Ireland, the euro gave an unsustainable boost to an already booming economy.


From 1995 to 2000, growth in Ireland accelerated to an average of 9.6 percent per year, and interest rates fell below German levels by 2005. Irish wages grew nearly five times faster than the Euro area average from 1997 to 2007, resulting in the real effective exchange rate (REER) increasing by 36 percent from 1999 to 2008, compared to an average increase of 13 percent in the other GIIPS.


This rapid growth and a European monetary policy that was far too loose for Ireland fueled the enormous overleveraging of the financial sector. The supply of credit exploded, surpassing 200 percent of GDP by 2008 after averaging around 40 percent from 1975 to 1994. In just ten years, financial and monetary institutions expanded their balance sheets by approximately 750 percent of GDP, and by 2007, gross financial exposure had reached nearly 1,400 percent of GDP. In the other GIIPS, balance sheets expanded by “only” 100 percent of GDP and exposure averaged close to 200 percent.

An extraordinary housing bubble emerged. From 1997 to 2006, housing completions grew by 9.6 percent a year, and by IMF calculations, Irish house prices grew by 90 percent more than fundamentals predicted, compared to 28 percent in Spain and 20 percent in the United States.


As in other GIIPS, the economy shifted away from manufacturing and toward services and housing. Financial intermediation, real estate, and business sectors sapped 10 percent of GDP away from the industrial sector from 1999 to 2006. Residential investment grew from 5 percent of GDP in the mid-1990s to over 12 percent by 2007.


Throughout the course of this boom, the Irish government appeared to behave responsibly, running an average budget surplus of 1.6 percent of GDP from 1997 to 2007, helped by surging tax revenues. Over that period, the aggregate Euro area never once recorded a surplus, and Greece averaged a deficit of 4.8 percent.

Ireland’s Massive Bust

In 2008, Ireland’s bubble burst. Over the next two years, domestic demand fell by 16 percent, investment collapsed by over 40 percent, and housing prices plunged 30 percent. By the end of 2010, Irish output will likely have contracted by 14 percent since the beginning of the crisis.


The financial sector was hit even harder. Financial equities plummeted by more than 70 percent. In June 2009, bank losses through 2010 were estimated to be as high as 35 billion euros, or 20 percent of GDP; since that estimate, nationalized Anglo Irish Bank announced losses of 12.7 billion euros, the biggest loss in Irish history.


The government responded to the financial crisis with extraordinary measures, issuing capital injections and guarantees to depositors and creditors of major banks and purchasing troubled assets. The total assets of the guaranteed banks are now valued at 440 billion euros, or 270 percent of Irish GDP and 2700 percent of Ireland’s average yearly net debt issuance.

 IS ITALY THE NEXT GREECE?

To maintain its membership in the Euro area and avoid its own disastrous sovereign debt crisis, Italy should, as a first step, adopt a three-year program to raise its primary balance by at least 4 percent of GDP and engineer a real devaluation vis-à-vis Germany of at least 6 percent through wage cuts and far-reaching structural reforms. Compared to the programs enacted or planned in Greece, Ireland, and the Baltic countries whose crises have already erupted, these steps are modest and should be interpreted as preemptive.

However, action in Italy and other vulnerable countries will not be enough: the Euro area must ease the painful adjustment by maintaining expansionary policy and targeting a weaker euro. To ensure that the global recovery continues, the G20 also has a vital interest in accommodating the lower euro.
 
 
 
The Post-Euro Boom and the Crisis Bust
 
After Italy and Greece adopted the euro in 1999 and 2001, respectively, interest rates in both countries fell to near German levels (the lowest in the Euro area), fueling consumer spending and house prices, particularly in Greece. Though the two governments used the lower borrowing costs to increase spending, they were also able to reduce deficits and debt. In Italy, debt fell by 10 percent of GDP from 1999 to 2007. Greece cut its debt by a larger 12 percent of GDP over the same period. This was a step forward, though other highly indebted countries, such as Belgium, did much better.

Since the outbreak of the crisis, debt in Greece and Italy has surged, as in other countries. In 2008 and 2009, Greece ran public deficits twice the size of Italy’s and added about twice as much debt as a share of GDP. But the fact remains that Italy’s debt load today is similar to that of Greece. 

With a public debt of 115 percent of GDP and interest rates near 4 percent, Italy must spend about 4.5 percent of GDP a year just on interest—the equivalent of its public education budget this year. Moreover, even if public revenues are able to cover all expenditures, interest costs will still lead Italy’s debt to grow faster than its sluggish economy—which consensus expects to grow at an average annual rate of 3 percent in nominal terms over the next seven years. Therefore, the debt burden will grow larger each year unless the primary balance (the difference between public sector revenues and expenditures, excluding interest paid on the public debt) moves firmly into surplus. Since Italy’s debt is of relatively short maturity, Italy is potentially more vulnerable than other countries to a change in market sentiment.

 Lost Competitiveness and Low Growth Potential

Italy has lost as much competitiveness as Greece since joining the Euro area. Italy’s unit cost of labor rose 32 percent from 2000 to 2009, comparable to Greece’s 34 percent rise over the same period. To keep its unit labor costs level with those of Germany—where wages essentially kept pace with productivity—


Italy should have kept its wages nearly flat in nominal terms over the last decade. Italy’s competitiveness deteriorated even more against other large trading nations, including the United States, China, and Japan—all simultaneously large markets


for and in competition with Italian exports. Econometric studies conclude that falling total factor productivity is responsible for Italy’s low growth problem. From 1996 to 2004, total factor productivity in Italy declined at an average annual rate of almost 1 percent, while it grew by approximately 1 percent per year in Germany. Numerous structural issues have plagued Italy’s economy for decades. These include labor market rigidities and dual labor markets, small average business size, defective and excessive regulations, inadequate public services, insufficient competition in backbone services (including energy, telecommunications, and transport), and profound governance issues in the South.


The consequences of Italy’s lost competitiveness are massive: a recent European Commission study concludes that, from 1998 to 2008, exports of goods and services grew more slowly in Italy than in any other member country, Italy lost the most market share in its traditional geographic markets, and its market share fell by more than can be explained by cost considerations alone. Given Italy’s specialization in low-skill goods, its inability to resort to currency devaluation is particularly challenging.

Hostage to Fortune

Italy’s cycle of high debt and low growth has re-enforced itself for decades, but the uncertainty of the post-crisis world economy poses new risks. In the short term, continued failure by the Euro area to deal with the Greek crisis and contain its spread could easily lead interest premia to surge on both government and private borrowing, eventually stifling European demand. This would kill Italy’s fragile recovery by forcing greater fiscal adjustment and further depressing exports.


On the other hand, sustained global growth would come with higher interest rates and could mean another large oil shock this year or next. This would hit Italy—a heavily oil-reliant country that imports 93 percent of its supply and is limited in its ability to increase exports in order to pay more—particularly hard.


The most pernicious risk is that Italy will continue to lose competitiveness against Germany and other trading partners as the wage and productivity differentials continue to widen. Unchecked, this process will eventually strangle the economy’s ability to grow at all. Financial markets will react (or may anticipate the trend), forcing a Greek-sized surge in the cost of borrowing.

PORTUGAL’S GROWTH CHALLENGE

 As in the other GIIPS, the euro’s adoption led interest rates to fall sharply in Portugal—from an average of 12.3 percent in 1991–1995 to about 6 percent in 1996–2000—setting the stage for a consumption boom. Overly rosy expectations that Portugal’s GDP per capita—less than 60 percent of Germany’s from 1985 to 1995 in PPP terms, compared to 76 percent in Spain and 70 percent in Greece—would converge to Euro area levels likely further catalyzed the boom.Paradigm Lost:
Between 1995 and 2000, private savings dropped by about 7 percentage points of GDP, while average gross fixed capital formation had accelerated. Household and non-financial sector debt more than doubled in percent of GDP terms between the mid-1990s and 2002. Reflecting external borrowing’s role in financing consumption and investment, the current account deficit soared to 9.0 percent in 2000, up from near-zero in 1995.


Though tax revenues surged, fiscal policy was pro-cyclical, adding to the expansionary conditions. The primary balance deteriorated by about 3.5 percentage points of GDP between 1995 and 2001.
 
  After formal adoption of the euro, monetary policy in the Euro area, while clearly too loose for Greece, Spain, and Ireland, who saw housing booms, was too tight for Portugal, where housing investment as a percentage of GDP had declined over time and inflation had dropped. As household spending stalled amid high levels of debt and prospects seemed to deteriorate—with little actual GDP per capita convergence—the investment and consumption boom came to an end. Household consumption grew by an average of 1.5 percent per year from 2001 to 2007, compared to 3–5 percent in Spain, Greece, and Ireland. GDP growth averaged just 0.8 percent between 2001 and 2008.



Though the Great Recession did not hit Portugal as hard as the other vulnerable economies, it did lead GDP to contract by 2.7 percent in 2009. GDP is projected to grow by 0.5 percent in 2010 and 0.7 percent in 2011, driven by external trade as domestic demand is set to essentially stagnate. The downturn is also having a significant impact on unemployment, which reached 10.7 percent last month, up three percentage points from two years ago—a relatively modest increase by the standards of Spain and Ireland. In addition, the crisis severely affected public finances, with the debt level reaching 86 percent, up from 66 percent two years ago.

At the same time, labor productivity slowed, with average annual growth falling from 3.1 percent in 1995–2000 to less than 1 percent in the beginning of this millennium. Labor productivity was also well below EU average—32 percent in agriculture, for example—in all sectors of the economy. The country’s relatively low human capital formation and limited use of information technology partly explain this disappointing productivity performance. At 9 percent, Portugal’s labor force participation in tertiary education is the lowest in the Euro area, compared to 18 to 22 percent in Spain, Ireland, and Greece. Similarly, Portugal’s spending on R&D as a percentage of GDP is half of the average in the Euro area. Furthermore, its governance and business climate indicators are today among the lowest in the euro area.

Portugal could have taken the opportunity presented by the boom to move into higher value-added and faster growth sectors and toward a more outward-oriented production structure. Instead, its export structure was weighted too heavily toward traditional sectors. In addition, the government missed the opportunity to build a budgetary surplus—which would not only have balanced the budget, but would have also moderated the domestic demand boom and the excessive concentration in non-tradable activities. In hindsight, a tax structure weighted toward discouraging consumption and investments in non-tradables (e.g., housing) could also have been imposed.



Against the currently bleak outlook, the government has now devised a strategy to reduce its deficit from 9.4 percent in 2010 to below 3 percent of GDP by 2013. This would help stabilize the debt-to-GDP ratio at around 90 percent, compared to nearly 150 percent for Greece and 75 percent for Spain, according to their government plans.


The plan involves privatization, raising taxes on high earners and capital gains, and cutting civil servant wages and public investment spending. The recent announcement of tough austerity measures, including a 5 percent pay cut for top government officials and a 1 percent increase in the value added tax, is encouraging. However, the growth assumptions underlying the deficit reduction projections are overly optimistic.

CAN SPAIN OVERCOME THE AEGEAN FLU?

The challenges confronting Spain stem from the same source as those in Greece: a huge misallocation of resources and loss of competitiveness that began with the adoption of the euro. Spain’s non-tradable sectors—housing, government, and a broad array of market services—had grown far too big. Spain has a debt-to-GDP ratio that is half that of Greece and thus has more time and resources to fix its problems. However, its large deficits and the collapse of its post-euro growth model imply that its public debt could—if remedial measures are not taken—follow an exploding path.

The housing sector’s boom and bust has undeniably defined Spain’s crisis. At its peak, construction value-added reached 17 percent of GDP, compared to a peak of less than half that in the United States. In just ten years, Spain’s housing prices more than doubled, and, at the peak in 2006, Spain started more homes than the UK, Germany, France, and Italy combined, a significant share of which were sold to foreigners.



The housing sector’s boom was only one manifestation of a deeper structural misallocation, however. In the run-up to the euro, interest rates plummeted and confidence soared, leading domestic demand and inflation to rise more than 1.5 times faster than the Euro area average. A European monetary policy that was too loose for Spain reinforced these trends.


Amid this demand boom, the price of all non-tradable activities rose relative to that of tradables (whose price is set in world markets); investment and labor were pulled into these non-tradable sheltered sectors; and wages were bid up higher than in other Euro area members and in excess of productivity. Spain’s manufacturing sector, already small at the start of the process, shrank its share of GDP by 4 percent. Amid this boom, Spain’s tax receipts swelled temporarily, generating more revenue than expected. As a result, the government was able to rapidly expand spending—by 7.5 percent of GDP from 2005 to 2009—while creating the impression of solid fiscal management and maintaining a public debt-to-GDP ratio that was among the lowest in the Euro area. Though Spain’s government sector is smaller than that of some other large European countries, its rapid expansion contributed to Spain’s weak productivity performance.

Lost Competitiveness

Even as Spain’s economy boomed, growing almost 1 percent per year more on average than the Euro area from 1999 to 2007, its total factor productivity (TFP) fell behind. Between 2000 and 2008, TFP was essentially stagnant in Spain, compared to average annual growth of 0.9 percent in Germany and 1.4 percent in the United States. Spain’s non-tradables—including post, telecommunications, and transport—fared particularly poorly.


Nonetheless, booming demand led wages to grow faster in Spain than in its partner countries. Since 2000, Spain’s hourly labor costs have consistently outpaced those of the Euro area by more than 1 percent per year. Spain’s labor market rigidities, including a dual labor market that protects permanent workers and their wages, accentuated the rise. Spain’s unit labor costs (ULC), the average cost of labor per unit of output, have risen more than 30 percent since 2000, whereas Germany’s nominal wages have grown roughly in line with productivity.


Relative to the United States and Japan, which both saw ULC in euros decline by more than 20 percent (partly due to euro appreciation), Spain has suffered an even greater competitiveness loss. Though comparable figures are not available for China, enormous labor productivity increases and modest currency changes almost certainly caused ULC in euros to decline there as well.


Over the last decade, Spain’s exports have lost share in world markets but have roughly matched the advance of other Euro area exporters. This perhaps seems adequate at first glance, but is wholly unsatisfactory in reality, given that Spain’s productive capacity surged relative to that of its Euro area partners due to immigration and investment growth, and that its import demand expanded correspondingly.

In fact, exports as a share of GDP fell by 3 percentage points from 2000 to 2008 in Spain, compared to a rise of nearly 14 percentage points in Germany. While Germany grew its current account surplus, Spain’s plunged into deep deficit. In this regard, Spain shared the experience of Greece, Ireland, and Portugal, which also became excessively dependent on domestic demand and non-tradables.


Spain’s deteriorating national balance sheet reflected these trends. The country’s net foreign liabilities reached nearly 80 percent of GDP in 2007, third largest in the Euro area, and loans to households and non-financial corporations grew to more than 200 percent of GDP—more than double their level in 1998.

The Crisis

The Great Recession helped reduce the current account deficit and restore household savings rates, but it also crippled domestic demand and exposed the fragility of Spain’s growth model. Though world GDP is now growing, Spain’s economy is expected to contract an additional 0.4 percent this year. Spain’s banking sector weathered the crisis relatively well, but according to the IMF, its savings banks may see a net drain on capital of 2 billion euros—nearly 30 percent of their reserves for repossessions—if, as expected, unemployment rises and housing prices fall further.


The massive rise in unemployment—which crossed the 20 percent threshold in April—should be interpreted as part of the unwinding of the structural misallocation, as it reflects not only the effects of global trade’s collapse on manufacturing (which is now recovering) but also the collapse of demand for housing and non-tradable activities generally.

EUROPE BOUGHT TIME AND NOT MUCH ELSE

The package agreed upon in Brussels provides Europe’s embattled economies with a much needed respite and may even save the European integration project from the disaster of several countries being forced to shed the euro. It is all good news—that is, if it works.



Unfortunately for Brussels, however, whether or not the package works is not a decision that will or can be decided there. The real decisions needed to deal with Europe’s crisis will have to be taken in Portugal, Spain, and Italy. It won’t be easy; belt-tightening and tough choices are needed. This is something last week’s rioters in Athens seemed to understand all too well. Therefore, as the different countries attempt to reform their economies, expect street demonstrations in Lisbon, Madrid, and Rome.


Before raining on the parade, however, we should mention an upside to the Brussels package. The measures taken are important not just because of the unprecedented amount of money involved (the size of the financial package is larger than the economies of Finland and the Netherlands combined) but also because they mark the end of two dangerous ideas—and their promotion by European leaders.

First, the bailout requires Europe to admit that the eurozone setup is defective at its very foundation. The measures mark the end of the misguided hope that centralized monetary policy can co-exist with decentralized fiscal behavior. Since the single currency’s inception, interest rates and the money supply for the whole of Europe have been decided by a single entity, the European Central Bank (ECB), while taxes and public expenditures remain under the control of each national government. The recent decisions explicitly recognize that a monetary union is as weak as its weakest link and, as such, requires strong fiscal coordination. Inevitably, this means that countries will have to cede some of the autonomy that they have thus far used to (mis)manage their fiscal affairs. On the other side, the ECB’s decision to buy government bonds is also a landmark, eliminating the pretense that the central bank will not help governments in difficulty under any circumstance.



Second, the measures also mark the end of the pretense that the eurozone can and will take care of its problems without anyone else’s help. For this emergency, help was marshaled not only from other EU countries that are not members of the Eurozone but also from the U.S. Federal Reserve and the International Monetary Fund (IMF). The IMF will carry an unprecedented financial burden in support of Europe’s rescue, and its help never comes without stringent conditions: The IMF will play a central role in dictating how Europe has to behave in order to access the funds it needs.


Shedding these illusions is good news. But that’s where the good news ends. For a start, 750 billion euros represents only about eighteen months of the financing requirements for Europe’s most obviously vulnerable countries, which, contrary to pretense, also include Italy, whose debt burden and labor cost disadvantage is as high as that of Greece. The solution to their problems—a loss of competitiveness, inflated government payrolls, and rigid labor markets—obviously won’t come with a new borrowing facility. These measures only buy time, and not very much time at that.

THE EURO CRISIS IS BIGGER THAN YOU THINK

The eight newest European Union (EU) members (Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, and Romania) are committed to eventually adopting the euro. But, all already suffer from the problems that dragged the GIIPS—Greece, Ireland, Italy, Portugal, and Spain—into crisis: lost competitiveness, widening external deficits, and deteriorating public finances. However, the “peggers”—Estonia, Latvia, Lithuania, and Bulgaria, who have fixed exchange rates—are in much worse shape than the “floaters”—the Czech Republic, Hungary, Poland, and Romania. The structural distortions, including external imbalances, in all of the newcomers suggest that none of them will be ready to join the euro soon, as joining would likely only accentuate the distortions. When, or if, they adopt the euro, they should apply valuable lessons from the GIIPS’ experience so as to avoid painful adjustments later on.

The Initial Boom Among the Newcomers

The process through which the EU newcomers lost competitiveness was largely similar to the one in the GIIPS: lower interest rates and their expectations of rapid convergence to Euro area members’ economic fundamentals led to a boom in domestic demand. Deepening financial integration and low barriers to incoming capital, as well as reduced perceptions of exchange rate risk, particularly among the peggers, helped attract capital inflows. This furthered the demand surge, which saw domestic demand grow by more than 10 percent annually in the three Baltic states (Estonia, Latvia, and Lithuania) and by nearly 9 percent annually in Bulgaria from 2002 to 2007. The price of non-tradables rose compared to tradables and labor markets tightened—inducing wage increases well in excess of productivity. The deterioration of competitiveness soon resulted in large macroeconomic imbalances. Economic activity was pushed above potential, and the output gap (the difference between actual GDP growth and potential GDP growth as a percentage of potential GDP) in the three Baltic states grew to be very large. The phenomenon was less pronounced among the floaters, but Romania and the Czech Republic also observed rapid output gap growth.


Real effective exchange rates, based on unit labor costs, appreciated significantly in most of the newcomers, particularly in Latvia and Romania. This was reflected in the deterioration of their export performances, especially among the peggers. The external trade balance widened by 10 percent of GDP in Bulgaria and 14 percent of GDP in Latvia, from 2002 to 2007.

Peggers and Floaters

Both external and domestic imbalances have grown to be much more pronounced in the peggers. While a fixed exchange rate appeared advantageous during the pre-crisis boom when the peggers grew faster than the floaters, the downturn that followed has also been much greater in the former.



After joining the EU, the peggers saw wages grow at double-digit average annual rates from 2004 to 2008. The average rate reached about 25 percent a year in Latvia—more than ten times the Euro area average. Unaccompanied by matching productivity increases, this led unit labor costs (in euros) to nearly double in Latvia and grow 45–60 percent in Estonia and Lithuania—significantly faster even than in the GIIPS. While unit labor cost increases were generally moderate among the floaters, Romania saw an increase of about 90 percent.


The sharp drop in capital inflows after mid-2008 to the Baltics, which experienced the largest surge in inflows before the crisis and relied on foreign banks to fund credit growth, resulted in a deeper downturn. In 2009, domestic demand fell by about 25 percent in the Baltics—almost eight times the decline in the Euro area—and by about 15 percent in Bulgaria. Unemployment, which had been declining amid the pre-crisis domestic demand boom, shot up in 2008 and 2009, with the increase ranging from around 9 percentage points in Estonia and Lithuania to double-digits in Latvia.

The floaters enjoyed a less pronounced boom, but, with a wider range of policy instruments at their disposal, they were also able to moderate their recessions. GDP contracted by 4–7 percent in Hungary, the Czech Republic, and Romania in 2009, still greater than the Euro area’s average contraction of 4.1 percent but much less than the peggers’ contraction. Currency depreciation and expansionary monetary policy helped. The currencies in Hungary, Romania, and the Czech Republic depreciated by 10 to 20 percent against the euro from the third quarter of 2008 to the second quarter of 2009, while Poland’s zloty depreciated by more than 30 percent, giving the economy a needed export boost. Poland was the only EU country to register positive growth in 2009. However, given the severity of the liquidity crunch, several of the floaters were forced to rely on IMF support.

Paradigm Lost: The Euro in Crisis

Read the original story at Israel’s Financial Expert

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