Europe: The Competitiveness Problem

PART 2: Two experts question the eurozone’s response to the debt crisis and wonder whether it’s possible to repair the damage

Ben Johnson 13 March, 2012 | 1:51PM
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Ben Johnson is director of European ETF research with Morningstar. George Magnus is a senior economic advisor at UBS. Magnus was one of a handful of economists who warned of a pending global financial crisis as early as 2007. Edward Chancellor is a member of the Asset Allocation Team at GMO. Chancellor has written extensively on the topic of the current crisis, specifically examining the ways in which the eurozone’s predicament differs from historical sovereign defaults.

The Competitiveness Problem
Johnson: One of the main motives for leaving the common currency would be to inflate away the value of one’s debt. But as we’ve seen, that is just a near-term and not a long-term solution. A long-term solution is to regain competitiveness. Isn’t it one of the more elemental issues that the eurozone is facing? Certain peripheral members have just fundamentally lost their competitiveness.

Chancellor: I think that some of the data is a bit confusing because people often choose 2000 as a starting point to compare unit labour costs with Germany. They then point out how Italy’s unit labor costs have risen relative to Germany’s. But in fact, the starting point was probably a period in which the German unit labour costs were relatively high, compared with the periphery’s. We’ve been doing a lot of work on Italy, and Italian exports actually have been very strong over the last year. In fact, they’re only just about 1 percentage point behind Germany’s. So, it doesn’t look to me, in terms of export growth, that Italy has a particular problem. Ireland has deflated its unit labour costs by a great chunk over the last few years and is now back to around a current account surplus. Spain, I think, is the most worrying on the competitive front. But perhaps George has a different view.

Magnus: Not necessarily. There are obviously quite a few horses for courses already that we’ve seen since the crisis began, Ireland being the case in point, and other smaller economies like Latvia and Estonia. I agree that Italy’s competitiveness problem is not quite as blatant as Spain’s and Portugal’s, from the pure point of view of labour costs—although I think most countries in Europe did suffer to some degree, compared with Germany, over the last several years.

But the competitiveness problem can also be couched in terms of the inability of countries like Italy and Portugal to really grow. A little anecdote concerning Italy: Since 1999, when the monetary union started, Italy’s fixed-asset investment grew by half as much again as Germany’s, but it only got about half as much GDP as was recorded in Germany. In other words, Germany’s return on investment is substantially higher, maybe twice as high, than Italy’s. And one of the reasons that people have suggested for this can be found in the World Governance Indicators, which is published annually by the World Bank. Over the last 10, 11 years, Italy has slid down the rankings very rapidly in terms of things like operation of the rule of law, effectiveness of government, and spread of corruption. These kinds of things are not easily fixable.

So, the problem is-from the point of view of sovereign solvency, which is the immediate issue, even though we could present all sorts of math that shows that Italy could fund itself reasonably for a little while longer even at current interest rates-that without growth, the debt trap that Greece has fallen into is likely to become more widespread and could easily happen to Italy. Italy will have a recession, quite a deep recession, in 2012, which means that all of the best-laid plans of [prime minister Mario] Monti’s government to meet demanding deficit targets will continue to retreat into the future.

So, competitiveness is part of the whole imbalances problem. It can be seen both from an export and a unit labour cost point of view, but also from a wider perspective, which is the ability of the country to grow. We’re not trying to excuse debtor countries from having to do public sector reform and fiscal restraint over the medium term. But we’d like them to be able to find ways of regaining growth that would enhance competitiveness without having to rely solely on an internal devaluation, which is the extraordinary reduction in wages, costs, and prices that countries have to endure.

Chancellor: At GMO, we’ve created an index, comprising a number of competitiveness and corruption indices-the Corruption Perceptions Index, the Index of Economic Freedom, the Ease of Doing Business Index, the Global Competitiveness Report, the Economic Freedom of the World Report. We then looked at the eurozone countries and found, to no one’s surprise, that Greece scored the worst. Italy, I’m afraid, came in second place with Spain and Portugal also registering negative scores. By the way, Ireland, which is often considered a so-called PIIGS country, actually gets a perfectly respectable score, more or less on par with the U.K. And, funnily, its score is even higher than Germany’s.

But when people start worrying that Italy cannot grow and that, therefore, the debt can never be paid back, it poses a problem, because Italy is—or at least was, until its bonds started falling-the third-largest government-bond market in the world. The thought of the third-largest government-bond market in the world not functioning properly is a very, very serious problem.

George will know that Britain in the 19th century had a debt burden—much larger than even Japan today. But because it was a relatively peaceful time, because the government didn’t have many welfare obligations, and because the laissez-faire economics, for better or for worse, allowed the economy to keep on growing, Britain was able to reduce its government debt/GDP ratio from 1820 to 1914 from around 250% of GDP down to about 40% of GDP. They did it solely by growing the denominator. They didn’t actually pay back any debt; they rolled it over—the debt was perpetual. They did it by the economy growing.

So, it is very important that Italy grows. One hopes that Mr. Monti will make Italy an easier place to do business, and Italy’s economic potential will be released. Whether Monti has time to actually implement those reforms—whose fruits would take several years to grow-is another matter.

Johnson: What are some of the precursors to sustainable growth in the periphery? What has to happen for these countries to instill confidence in their markets so they can make structural reforms and grow their economies?

Magnus: It’s going to be really difficult for the debtor countries of sovereign Europe to set themselves onto a growth path. I don’t think they’re going to be successful in the absence of some kind of symmetry in the behaviour of creditor countries as well. There is a basic inconsistency in the German position. Not that the Germans have actually said this, but in effect, what they’re saying is, “We need everybody to become more disciplined like us.” They haven’t said, “Everybody needs to be a surplus country,” which of course is nonsense, but effectively, that’s kind of the thinking behind the current policy stance.

If countries-Italy, Spain, Greece, Ireland, Portugal, even France—have to set a course to save more-i.e., in the process of deleveraging public and private sector debt-then obviously within the monetary union the integrity of that arrangement will only endure if their increased savings can be offset by somebody else’s reduced savings. Even though there is a strong case for more labour-market flexibility, public-sector reform, restructuring of public expenditure, and so on, I just don’t think these things can actually help them return to economic growth in the absence of adjustments by creditor countries, of which Germany is the largest, and a more proactive position by the European Central Bank, which can provide the kind of bridge financing via quantitative easing that’s necessary for structural economic changes and adjustments to work. But at the moment, very little of this is on the agenda.

So, when you ask for precursors, a de minimis precursor is that debtor countries should be trying to do their adjustments over a reasonable period of time and not trying to rush it through in the next two years, whilst making employment the litmus test of pretty much everything they do in terms of structural reform from a macroeconomic perspective.

And as I said, that on its own is unlikely to lead them to success. It requires the creditors, mainly Germany, to imagine that they have some self-interest in structural reforms, too, even though it may not have seemed like that to the German government and to German voters. It will make them less of an export, surplus-centric country, less mercantilist. I realise that I’m whistling in the dark by saying that, but that’s the underlying reality of it.

Chancellor: One of the ways I started to think of what is the central problem of the single currency is in terms of a so-called trilemma, when you have three different objectives and it’s impossible to achieve all of them simultaneously. The famous trilemma in economics was identified by Robert Mundell and Marcus Fleming, who observed that a country couldn’t have a fixed exchange rate and an open capital account while keeping inflation under control.

The Germans have a slightly different trilemma. They have three different desires. First, they want the single currency to survive, because if it doesn’t survive, the German financial system is in a very perilous state. Secondly, they want to limit the amount of money they are paying to the periphery in terms of bailouts or future support. And thirdly, they want the European Central Bank to keep to its mandate to keep inflation low. I don’t think you can have all three of those together. I don’t think the single currency will survive if you put the periphery through a deflationary bust with Germany refusing to put its hands in its pockets to provide large, continual transfers to the periphery. But that seems to be the course we’re on at the moment. The Germans haven’t budged from that position.

Now, one potential solution is that they relax on the inflation side of things. I’m not in general an inflationist, but if Germany accepted a higher level of inflation, then the uncompetitiveness of the periphery would diminish. They wouldn’t have to go through a deflationary bust because German unit labour costs would rise relative to the periphery.

I’m not saying that it’s in the cards, but if you had a weak euro and very strong relative credit growth and money supply growth in Germany, and that fed through into a boom in Germany— and this would answer George’s desire that Germany begin to run a current account deficit—then the eurozone might hold together.

But the Germans are quite stubborn. They’re not very good at economics. I hate to say it, but they’re not very good at finance, either. And they’re quite puritanical. So, they are setting Europe on this disastrous course.

Magnus: The great inflation of the 1920s is in German DNA as much as the Great Depression is in ours. The reunification of Germany itself gave Germans additional cause to reflect on the implications of what was for them an explosion in their fiscal deficit and in their bond yields and in inflation.

Chancellor: It’s true that the Germans remember the inflation of the early 1920s, but they appear to forget the deflation of the late 1920s and early 1930s. It was the deflation-with Germany going back onto the Gold Standard, wringing inflation out of the system-that set the political preconditions for the rise of the Nazis. Inflation preceded it, but it was the deflation that was so politically destabilising. And exactly the same, I’m afraid, can be said for Japan in the 1930s. So, the Germans may fear inflation, but we know that inflation is, when you have too much debt, the path of least resistance. Default is a much more painful route. If the Germans really want to go down that route, they may one day rue it.

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Ben Johnson

Ben Johnson  is director of passive funds research at Morningstar.

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