Friday, November 28, 2014

Europe’s 4% Solution

WASHINGTON, DC – This is a momentous summer for Europe, because both the eurozone and the European Union could be in danger of unraveling, despite the important steps toward a banking union and direct recapitalization of Spanish banks taken at the June meeting of eurozone leaders. Implementation of the proposed reforms is lagging; there may be legal challenges to the European Stability Mechanism in Germany; and the Netherlands and Finland seem to be backtracking on some parts of the agreement.

Even in a worst-case scenario, some degree of intra-European cooperation will surely survive. But it is hard to see how the EU as we know it could survive even a partial disintegration of the eurozone.

Those who argue that one or more countries on the eurozone’s periphery should take a “holiday” from the euro underestimate both the economic and political repercussions of such a move. The sense of failure, loss of trust, and the damage inflicted on so many if two or three countries had to leave would shake the entire Union.

One of the key challenges is the negative feedback loop between the weaknesses of many banks and the doubts about the peripheral countries’ sovereign debt. The sovereign-debt and banking crises have become even more closely interlinked as banks bought greater amounts of their home countries’ sovereign debt.

That said, Europe’s disparities in production costs and competitiveness, reflected in the “problem” countries’ substantial current-account deficits, may prove to be an even more difficult problem to resolve. Unit labor costs in Greece, Portugal, Spain, and Italy grew 20-30% faster than in Germany in the euro’s first decade, and somewhat faster than unit labor costs in northern Europe as a whole.

This disparity reflected some differences in productivity growth but even more so differences in wage growth. Broadly speaking, capital inflows led to real revaluation and a lower domestic savings rate relative to investment in the southern countries, resulting in structural current-account deficits. In Greece, large fiscal deficits accompanied and exacerbated this trend. In Spain, the counterpart to the current-account deficit was private-sector borrowing.

The eurozone crisis will not be resolved until this internal imbalance is reduced to a sustainable level, which requires not only fiscal adjustment in the troubled peripheral economies, but also balance-of-payments adjustments across the eurozone as a whole. That, in turn, implies the need for a real exchange-rate adjustment inside the eurozone, with peripheral countries’ production costs falling relative to those in the core.

Real exchange-rate adjustments inside a monetary union, or among countries with fixed exchange rates, can take place through inflation differentials. The real value of the Chinese renminbi, for example, has appreciated considerably relative to the US dollar, despite limited nominal exchange-rate changes, because China’s domestic prices have risen faster than have prices in the United States.

A similar adjustment within the eurozone, assuming similar productivity performance, would require wages in the troubled peripheral countries to rise more slowly than in Germany for a number of years, thus restoring their competitiveness. But, because Germany and the other northern surplus countries remain hawkish on price stability, real exchange-rate adjustment within the eurozone requires actual wage and price deflation in the distressed southern economies.

This pressure on the peripheral countries to deflate their already stagnant economies is turning into the eurozone’s greatest challenge. The ECB’s provision of liquidity can buy time, but only real adjustment can cure the underlying problem.

That could be achieved with less wage contraction and loss of real income if productivity in the peripheral economies were to start growing significantly faster than in the core, thereby allowing prices to fall without the need for lower wages. But, while structural reforms could undoubtedly lead over time to faster productivity growth, this is unlikely to happen in an environment in which credit is severely constrained, investment is plummeting, and many skilled young people emigrate.

Price deflation is not conducive to bringing about the sort of relative price changes that could accelerate reallocation of resources within the countries under stress and increase overall productivity. Relative prices are much easier to change when there is modest inflation than when nominal price reductions are required. The need for higher productivity in the troubled countries is undeniable; but achieving it in the current climate of extreme austerity and deflation is unlikely, given an atmosphere of latent, or open, social conflict.

These economic adjustments could occur much more smoothly if the eurozone as a whole were to pursue a more expansionary policy. If the target inflation rate for the eurozone were to be set temporarily at, say 3.5%, and if the countries with current-account surpluses encouraged domestic inflation rates somewhat above the eurozone’s target, there could be real price adjustment within the eurozone without price deflation in the troubled countries. There are finally some signs that Germany will welcome more rapid domestic wage growth and somewhat higher inflation.

This could and should be accompanied by an overall depreciation of the euro, though that would be no panacea. High public-debt levels would still have to be reduced to create fiscal space and keep interest rates low enough to restore long-term confidence. That means that courageous structural reforms must still be pursued in the peripheral countries – indeed, throughout Europe.

Similarly, the eurozone would still need to strengthen its firewalls, as well as its mechanisms for cooperation. But a temporary and modestly higher inflation rate would facilitate the adjustment process and give reforms a chance to work.

Deflation discourages optimism about the future. Shifting the entire adjustment burden onto peripheral countries with current-account deficits, while core countries continue to run surpluses, obstructs adjustment.

The eurozone’s inflation target is not a magic number, and it is irrational to let it determine the overall macroeconomic framework. If lower is always better, why not set the target at 1%, or even zero? In fact, there are times when 3-4% is better than 2%. Europe is at such a moment.

Read more from our "The Inflation Fixation" Focal Point.

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    1. CommentedPieter Keesen

      Great article! It illustrates the complexity of the European debt program, and shows for a multifaceted solution to be the best remedy to resolve the sever financial and economic disparity within the Euro-zone. Indeed, the number fetish of the European stability agreement seems irrelevant at this point in time. Indeed, the Euro-zone will disintegrate if the core-countries will try and make for the periphery to readjust the imbalance by a harsh wage-policy.
      Yet I miss two notions that are part of the European problem which I believe are intertwined with the financial and economic conflicts within Europe. First the lack of mobility in the labor market, second the issue of corruption and political culture.
      The EU is first and foremost a market place, at least it was designed as such. This also means Europe has one common labor market. Yet the reality of this common labor market has proven a fallacy. Language and cultural barriers prevent for the integration of the labor market.
      Now the authors of this article propose a divergence of wage policy within the Eurozone. German and Dutch employees are to earn more, Spanish and Italian employees are to earn less. I doubt if this is politically possible, and to what extent migration will countermand such an approach.
      Secondly, the difference in political culture, especially with respects to corruption, are to be adressed before the northern Europe even entertains the thought to make the South more competative at the expense of the north. In the financial sector it is called moral hazzard, to reward people or systems for failure. In short, the Germans and Dutch and Finish people feel the south has let them down. The Spaniards, Portugues, Italians and Greeks had an oppertunity with the introduction of the Euro, and they have missed the oppertunity.
      There needs to be accountability. If Dutch and German Euro's are to bail out Spanish banks, and finance the budget deficeit of southern countries, it has to come at the expense not only of the Dutch and German tax payer. Spanish bankers are to pay too, Spanish home owners need to mend their own mistakes. I believe the European wellfare state is a great good, and nobody in Europe is to suffer abject poverty or grave injustice. Yet people should take their own responsibility, and southern States like Spain and Italy are advised to make the maximum effort to regain the thrust lost, and not only at the bond market or Northern Governments, but also the public in Holland and Germany and Finland. Because strangely enough I have not seen a Greek politican on the Dutch TV apologizing for the mess in Athens, thanking the Dutch public for their support. Perhaps a little PR would not hurt people!

    2. Commentedjames durante

      Economics is a subset of politics. An economic class with political power devises broad economic principles that reflect their own preferences. Laws are devised to implement these policies, and, ultimately, the coercive power of the state is used to repress anyone who challenges the basic set-up.

      In any society (save primitive cultures) the basic idea is to transfer most wealth to the dominant class. The recent crisis reveals a dominant financial elite that speculated wildly on high risk derivatives. When the house of cards began to fall, in stepped the state to bail them out. To this day, all efforts involve keeping the banks solvent and the bankers insanely compensated. For average people there is no end to the plans for austerity. But where is the auesterity for the financial elites that actually caused the mess?

      A more productive and just approach would be to nationalize major banks. Take toxic debts off their books, Reclaim from their senior officers as much of the ill gotten gains as possible, after firing them. Re-issue sovereign debt at a reduced value only to regular citizen investors or in pension funds or indexed funds, etc. Significantly raise taxes on wealthy people and corporations and close the thousands of tax shelters, dodges, deductions, etc.

      It would be a start.

    3. CommentedMark Pitts

      Best article on Europe that I've read in a long time - and even offers a workable solution.

    4. Commentednitin maganti

      At the expense of common man who is already losing this battle .Any rise in the inflation will have amplified repercussions .The problem will increase many fold if social unrest is added to this .

    5. CommentedRusty Rustylink

      Encouraging a little inflation may be a bad solution, but it may be the best available. Such an approach might well relieve slightly the pressures that politicians in Europe are unwilling/incapable of facing up to.

    6. CommentedProcyon Mukherjee

      There are three immediate implications if we at all pursue the approach as mentioned in the article. First of all, we have a situation where all the limiting conditions are simultaneously prevalent, which is government debt as a percent of GDP, non-financial corporate debt as a percent of GDP and private household debt as a percent of GDP is already touching an all time high. To top it we have government debt to revenue ratio touching alarming proportion. Secondly a BIS study released in June 2012 warns that budgets of most advanced economies, excluding interest payments, “would need 20 consecutive years of surpluses exceeding 2 per cent of gross domestic product - starting now - just to bring the debt-to-GDP ratio back to its pre-crisis level"; the increased burden on the ageing population and inter-generational transfer of debt would have further implications. Thirdly inflation targeting does not solve the fundamental malaise, which is boosting competitiveness of the Southern States, that needs to be seen through the metric of relative unit labor costs; perhaps only Ireland has made significant strides to bring down the divergence.

      Simply inflation targeting at 4% to foster growth by unprecedented levels of central bank actions is also fraught with risks for the long term.

      Procyon Mukherjee

        CommentedMark Pitts

        Re: Your third point: The authors did explain how a higher inflation target makes the competitive issue and relative labor cost adjustments much more manageable.