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.