Posted by: Dirk | February 18, 2010

PIIGS cannot fly, Mr Roubini!

In his article Teaching PIIGS to Fly Nouriel Roubini assures us that for the PIIGS (Portugal, Italy, Ireland, Greece and Spain) “restoring competitiveness, not just fiscal adjustment, is necessary to revive sustained growth.” In this note I will argue that under today’s circumstances the PIIGS cannot fly.

Nouriel Roubini states that three options could make the PIIGS take off again. The first one is this:

A decade of deflation would work, but it would be accompanied by economic stagnation, thus becoming – as in Argentina earlier this decade – politically unsustainable, leading to devaluation (exit from the euro) and default.

I agree with this point. It is not very likely though that this happens, since leaving the euro will turn debts into foreign debts denominated in euros. Since a new currency will depreciate against the euro this makes foreign debts balloon. Exit from the euro only makes sense in conjunction with a partial default on foreign debt.

Accelerating structural reforms that increase productivity while keeping the growth of public and private wages in check is the right approach, but it is likewise politically difficult to implement.

This is a long-run policy which has been advocated, among others, by Xavier Sala-i-Martin. However, the point here is that we are interested in relative developments of productivity and wages. Since the main trade partners are inside the eurozone, productivity has to rise higher than that of the trade partners, and wages have to rise less than that of the trade partners.

In the last years, productivity was rising most in France and Germany, so it’s very unlikely that the PIIGS can increase their competitiveness through productivity growth. This gets even more difficult by worsening public finances and the resulting threat to cut spending on education, health care and so on. These public goods have an influence on productivity which should not be forgotten.

What about falling nominal wages? Well, since wages have been stagnant in Germany, nominal wage cuts seem like the only solution to increase competitiveness. However, lower incomes means that it gets harder to repay any debts. Also, real estate prices will keep on falling, making the situation of over-indebted households in Ireland or Spain even worse.

Or a weaker euro could be had if the ECB were willing – quite unlikely – to ease monetary policy further to allow real depreciation. But a weaker euro would not eliminate the need for structural reforms; otherwise, the benefits would go mostly to countries like Germany that undertook painful reforms to restore competitiveness via a reduction in relative unit labor costs.

A weaker euro will affect competitiveness of eurozone members and divert trade from external to internal countries. It is likely that Germany would profit more than other countries by this. In that Nouriel Roubini is right. But then, all three measures will not make the PIIGS fly.

The eurozone is a currency area, and there are institutions in place which make it look and feel like one economy. It would be wrong to consider the eurozone as a group of national economies – they are not. They have a single market, they have one system of tariffs, they have labour mobility, one central bank, the European Court of Justice – they have to be considered as the United Nations of Europe. What before were nations by now are regions, and that means that the typical ideas of economic adjustment are out: no tinkering with the interest rate, no devaluation of the currency, no tariffs, and so on.

Is the eurozone doomed? Well, the eurozone was built by Europeans and these created some institutions while others were skipped. There is no fiscal policy in the eurozone, only smaller institutions which re-distribute money among the members, like the European Investment Bank. But €21 billion a year is not enough to deal with problems like those of today. There are some more funds which in theory could deal with the problem, like the structural funds. Objective 1 deals with promoting cohesion and convergence – it “promotes the development and structural adjustment of regions whose development is lagging behind, i.e. whose average per capita GDP is less than 75% of the European Union average”. Funding for 2000-2006 was €135.9 billion.

The eurozone can deal with the crisis, but it has to overhaul its institutions. The Stability and Growth Pact has to go, the ECB has to revise its policies, and some fiscal coordination would clearly help. Some institutions need mere fine-tuning while others must be reconstructed. Some – admittedly – hard to imagine quick&dirty fixes are also available to increase the productivity of the PIIGS, like inflating the German economy or a partial default on some of the debt or imposing tariffs between countries or providing the PIIGS with more loans. These can only be short-run solutions, but a break-up of the eurozone can be halted if that becomes necessary.  Given the political will to proceed with European integration, the euro can be saved. Otherwise, chances are that the EU scraps the euro and goes back to the situation of the 1990s.

The introduction of the euro meant access to cheap financing for the PIIGS, while countries like Germany stagnated. The boom in the PIIGS was unsustainable, and Germany’s net export earnings partly wasted through the financial crisis. German real wages and the DAX are today where they have been in 1998. The bond yields of the PIIGS have increased anyway by now, and abundant capital seeks investment opportunities in a situation of a global “savings glut”. Would the costs of euro exit really be larger than the benefits? Just asking.

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