Is the Euro Rescue Succeeding?

Authors: Uri Dadush, Bennett Stancil
Originally published by the Carnegie Endowment for International Peace

The new year has been kind to Europe: the euro has strengthened and bond spreads between Germany and Europe’s troubled economies have narrowed. However, evidence that countries are dealing adequately with the underlying causes of the crisis 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

Economic recovery is slowly taking hold in the core of the euro zone. Economic ministers are negotiating an expanded and more flexible European Financial Stability Facility (EFSF), expected to be unveiled at the European summit in late March or even sooner. A raft of new budget-cutting measures in Portugal and Spain, which 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 January 1, credit default swaps on the periphery countries have dropped by 25 to 150 basis points, the euro has strengthened by 2 percent against the dollar, and European stock markets are up 6 percent, more than other major indices. In addition, 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 no light at the end of the tunnel yet.

A drawn out affair

As many have argued from its outset, the euro 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. However, 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’s 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 labor 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 labor markets are relatively flexible, was a partial exception). Meanwhile, European monetary policy became too loose for the periphery, fueling a construction boom in Greece, Ireland, and Spain, and an unprecedented banking expansion in Ireland. The misalignments are clearly seen in the table below, particularly in the huge divergences between Germany and the others in unit labor costs and export shares.

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, 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 reestablishing competitiveness but is this occurring?

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

However, despite announced wage cuts across the periphery and the euro’s decline (down nearly 6 percent 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 periphery countries have lost further ground vis-à-vis Germany. Moreover, while world trade is booming again, consensus forecasts for 2011 expect the periphery countries to be stagnant or to shrink. Italy is projected to show 1 percent growth in 2011, as it did in 2010, but its GDP is still expected to be about 4 percent lower than its pre-crisis peak.

On this evidence, austerity appears to redress the competitive and structural divergences at only 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 labor markets. Absent these changes, the divergences between the periphery and core may not close, or may even widen again.

So far, each country has taken modest steps, but the measures have been insufficient. Though not yet reflected in competitiveness indicators, Greece alone appears to be embarking on far-reaching structural reforms as part of its EU-IMF program. This should not be too surprising: reforms such as liberalizing the markets for professional services attack powerful interest groups directly and nearly always require the application of an external force.

Rather than apply that force, however, policy makers in Brussels remain focused on fiscal consolidation and on how to finance the 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 EFSF 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 euro zone 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.

A different tack

So what should be done differently?

First, leaders in the euro zone must recognize 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 the inclusion of conditions that maximize the incentives for 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) that involves mainly public creditors and bond repurchases on the open market should be preserved.

Third, the core countries must recognize 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 percent would be just perfect, the former, not the latter, is the main objective.

In 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 reestablished can the euro rescue be deemed a success.