Thursday, November 27, 2014

A Second Chance for European Reform

MUNICH – The European Central Bank has managed to calm the markets with its promise of unlimited purchases of eurozone government bonds, because it effectively assured bondholders that the taxpayers and pensioners of the eurozone’s still-sound economies would, if necessary, shoulder the repayment burden. Although the ECB left open how this would be carried out, its commitment whetted investors’ appetite, reduced interest-rate spreads in the eurozone, and made it possible to reduce the funding of crisis-stricken economies through the printing press (Target credit).

This respite offers an ideal opportunity to push forward with reforms. Greek Prime Minister Antonis Samaras must convince his countrymen that he is serious about implementing them. Spanish Prime Minister Mariano Rajoy and Portuguese Finance Minister Vitor Gaspar deserve more support for their plans. And one can only hope that Italy’s caretaker prime minister, Mario Monti, contests the next general election. All of these leaders understand what must be done.

France, by contrast, does not appear to have noticed the writing on the wall. President François Hollande wants to solve his country’s problems with growth programs. But when politicians say “growth,” they mean “borrowing.” That is the last thing that France needs.

France’s debt/GDP ratio is already around 90%; even if its 2013 budget deficit does not exceed 3.5% of GDP, its debt/GDP ratio will have climbed to 93% by the end of the year. The government’s GDP share, at 56%, is the highest in the eurozone and second highest among all developed countries.

It is not only film actors like Gérard Depardieu who are leaving the country to escape its high taxes; industry is fleeing as well. France’s once-proud carmakers are fighting for survival.

Indeed, France’s manufacturing industry has shrunk to barely 9% of GDP, less than Britain’s manufacturing share (10%) and less than half of Germany’s (20%). Its current account is sliding into an ever-deeper deficit hole. Unemployment is rising to record levels.

France’s basic problem, like that of the countries most affected by the crisis, is that the wave of cheap credit that the euro’s introduction made possible fueled an inflationary bubble that robbed it of its competitiveness. Goldman Sachs has calculated that France must become 20% cheaper to service its debt on a sustainable basis.

The same is true of Spain, while Italy would have to become 10-15% cheaper and Greece and Portugal would need domestic prices to fall 30% and 35%, respectively. The OECD purchasing-power statistics paint a similar picture, with Greece needing to depreciate by 39% and Portugal by 32% just to reach the price level prevailing in Turkey. But, so far, virtually nothing has been done in this respect. Worse, some of the troubled countries’ inflation rates are still running higher than those of their trading partners.

Eurozone politicians tend to believe that it is possible to regain competitiveness by carrying out reforms, undertaking infrastructure projects, and improving productivity, but without reducing domestic prices. That is a fallacy, because such steps improve competitiveness only in the same measure as they reduce domestic prices vis-à-vis eurozone competitors. There is no way around a reduction in relative domestic prices as long as these countries remain in the currency union: either they deflate, or their trading partners inflate faster.

There is no easy or socially comfortable way to accomplish this. In some cases, such a course can be so perilous that it should not be wished upon any society. The gap is simply too large between what is needed to restore competitiveness and what citizens can stomach if they remain part of the monetary union.

In order to become cheaper, a country’s inflation rate must stay below that of its competitors, but that can be accomplished only through an economic slump. The more trade unions defend existing wage structures, and the lower productivity growth is, the longer the slump will be. Spain and France would need a ten-year slump, with annual inflation 2% lower than that of their competitors, to regain their competitiveness. For Italy, the path toward competitiveness is shorter, but for Portugal and Greece it is substantially longer – perhaps too long.

Italy, France, and Spain should be able to regain competitiveness in the eurozone within a foreseeable period of time. After all, Germany cut its prices relative to its eurozone trading partners by 22% from 1995, when the euro was definitively announced, to 2008, when the global financial crisis erupted.

Ten years ago, Germany was like France is today – the sick man of Europe. It suffered from increasing unemployment and a lack of investment. Most of its savings were being invested abroad, and its domestic net investment share was among the lowest of all OECD countries. Under growing pressure to act, Gerhard Schröder’s Social Democratic government decided in 2003 to deprive millions of Germans of their second-tier unemployment insurance, thus paving the way for the creation of a low-wage sector, in turn reducing the rate of inflation.

Unfortunately, thus far, there is no sign that the crisis countries, above all France, are ready to bite the bullet. The longer they cling to a belief in magic formulas, the longer the euro crisis will be with us.

Read more from our "Zone Defense" Focal Point.

  • Contact us to secure rights


  • Hide Comments Hide Comments Read Comments (10)

    Please login or register to post a comment

    1. CommentedCarol Maczinsky

      The ECB was not authorised to guarantee that. We cannot accept anarchism from the top, robber central banking.

    2. CommentedGerald Silverberg

      Bravo, Herr Sinn!

      That the internal devaluation you advocate is self-defeating (and moreover, quite aside from the concomitant social unrest, is very hard to accomplish), has finally dawned even on the IMF. Since the real outlier in Eurozone unit cost evolution was always and almost exclusively Germany (France in fact was the one Eurozone country in macro equilibrium, with nominal wage growth equal to productivity growth and targeted inflation), did it ever occur to you that it would be much easier for everyone concerned for Germany to inflate the EZ back into relative competitiveness balance by raising its labor share and devaluing the Euro than to condemn everyone else to deflationary collapse (see my NY Times op-ed from 2011 (

      Prescribing the German (and Chinese) race to the bottom of lowering labor share is a recipe for global macroeconomic unsustainability, even if it has been in Germany's economic interest until now. But it is hard to imagine that the author of "Die Basar-Ökonomie", which predicted the decline of the German export powerhouse in 2005, could put two and two together to understand that universal austerity and wage deflation is a recipe for disaster (and now is plunging even Germany into recession).

    3. CommentedAlexander Stingl

      The construction of the Euro and the EU was supposed to be built on more than just the economic pillar originally. It was the mentality of influential lobbyists and propagandists for a neoliberal rationale, which Hans-Werner Sinn stands for, that sounded the trumpet for the idea that the sole pillar that was needed was the economic one and that all else would follow naturally because their religion, their faith in the "invisible hands" and this God-like entity "the Market", would be enough to create a commonwealth for all. The warnings of those saying that you cannot stand on one leg for long was silenced by the noise of the trumpets, and on they marched into the crisis of today. Whom did this religion help? Those who continue to sell the neoliberal agenda in selling their trumpets (books, articles, interviews, economic studies). The only solution is to stop listening to pundits who continue to think in nationalistic economies and territorial solutions, and to create genuine long-term solutions for a united European society in a post-colonial world.

    4. Portrait of Pingfan Hong

      CommentedPingfan Hong

      From a domestic point of view, it seems unfair and miserable for those European countries mentioned in the article to have to reduce their price level ( thus wage level ) by 20 per cent in order for them to become competitive at the international level. However, from emerging economies point of view, it is perfectly fair: why should a worker in Europe earn 20% per cent more than a worker in Turkey if both of them do the same job? From the global point of view, it is a natural process of convergence among countries: no countries are entitled to stay advanced forever in terms of productivity and living standard.

    5. CommentedShane Beck

      France suffers the common fate of countries like Italy, Spain and Greece than have shacked themselves to the German giant: they simply cannot compete with it in value added exports. They either have to opt out of the common currency to make their exports competitive or the have to delegate all their economic decision making, hence sovereignty, to a supranational economic body. There is no middle way and countries like Greece, Italy, Spain and France are deluding themselves if they think otherwise.

    6. CommentedAntónio Correia

      Recently, Paul Krugman said that "The Euro is a shaky construction" – and no one can deny this statement. The Euro has been designed – by Delors et al – as a "single currency" instead of a (much more realistic) "common currency", and now it is very clear that this was a very bad choice. It is quite obvious that the “bad romance” between France and Germany must come to an end and be replaced by a solid, long lasting friendship:

      Twenty years after the Maastricht Treaty, a "Maastricht 2.0" Treaty is required, as soon as possible, so as to avoid a sad situation, in the near future, where the foreseen "European common home" becomes replaced by a true "European house of correction". We need to build a true European Union through a cooperative European disunion:

    7. CommentedCristina Martello

      I believe that domestic prices reduction is not the only way to gain competitiveness and it shoul not be the tool or at least the only tool European leader should use.

    8. Commentedserge d'agostino

      Very interesting from a liberal economist: the sources of our problems in Europe, namely the lack of real cooperation between States, austerity considered as a dogma and that those who sin must atone in pain.

      Never he refers to non-cooperative game in which is engaged Germany since the late 90s (in contrast, the German example is touted without our author thinks a moment that if all countries do the same thing we will be in a scenario of race to the bottom as in the 30s. The main thing to do is to reduce wages and social contributions in countries already struggling and not a word about the revaluation salary or recovery activity that Germany should / could deliver.
      Moreover our author considers that France adopted a stimulus policy: what a surpise! And read the end of the text: Greeks, Portuguese, Spaniards, Italians and ourselves, will appreciate). I think Sinn need a rest!

    9. CommentedFrank O'Callaghan

      How revealing!
      "Gerhard Schröder’s Social Democratic government decided in 2003 to deprive millions of Germans of their second-tier unemployment insurance, thus paving the way for the creation of a low-wage sector, in turn reducing the rate of inflation."
      The theory is that to be economically prosperous a country has to further impoverish and deprive those who work or have worked in order to enrich those who speculate.
      Intellectually shameful and morally bankrupt!

    10. CommentedLucas Klostermann

      Interesting analysis - inflation being an important part of competitiveness over time, in particular in absence of an exchange rate.
      It strikes me that the competitive comparison is primarily towards other EU or neighboring countries. With most of the EU countries exporting primarily to other EU countries, this seems indeed a very important perspective.
      However, in my perception an important argument used for the Euro and tighter collaboration within the EU is often the outside world; individual EU countries being feared to be irrelevant against the US, China or other large developing countries. What we have created with the Euro now is a currency union where a major instrument without the perils and strong social discomforts that Prof. Sinn refers to, has been taken away from national governments and/or financial markets; exchange rates and devaluation. Towards the main trading partners within the EU this instrument is dearly missed, towards the outside world having a Euro or not is maybe not that important.
      I am curious how others view this, and hope for a positive twist.