Over the coming 18 months, prospects for economic activity in the euro area are bleak. Within the recently published Goldman Sachs Euro Area Outlook note, we forecast that the current recession will extend well into next year, with at best sub-trend growth envisaged for 2014.
Deleveraging and fiscal consolidation are the immediate causes of this economic weakness. By reducing spending, both weigh heavily on real activity but both are also elements of a necessary adjustment.
The euro area entered the financial crisis needing to correct significant financial and economic imbalances: in this context, acting to strengthen both public and private balance sheets via consolidation and savings is necessary, not optional. At stake is the pace and efficiency of the unavoidable adjustment process.
The resulting “growth vs austerity” debate is not unique to the euro area: it is familiar across advanced economies, not least here in the United Kingdom.
Indeed, if treated as a single consolidated entity, the fiscal and external imbalances faced by the euro area are (in general) smaller than those seen in the US, the UK or Japan. Other things being equal, the challenge of adjustment should be more manageable.
But treating the euro area in such a consolidated way is, at least at the moment, merely a statistical exercise. It has no basis in economic or political reality.
Rather than benefiting from its (relative) collective strength, the euro area is only as strong as its weakest link. And, on various dimensions, that weakest link is weak indeed. What’s more, these weaknesses have proved to be self-reinforcing.
Where euro area countries have accumulated large macroeconomic imbalances, the viability of their continued use of the euro as their currency has come into question.
Once financial markets entertain doubts over whether membership of the euro area is sustainable, default and redenomination risks emerge, a country’s borrowing rates rise, markets segment and a vicious self-sustaining cycle of weaker growth and tightening financing conditions is set in train, which serves only to validate concerns about sustainability.
The Greek experience illustrates as much. In these circumstances, the painful but necessary adjustment at the area-wide level can become a catastrophic dislocation in vulnerable participating countries, threatening both social cohesion in the nation concerned and the integrity of the system as a whole.
Finding the means to correct macroeconomic imbalances is therefore crucial if the euro is to become a workable currency.
And countries’ external balances – the current account and external debt – are central in this respect. Why did these imbalances emerge in the periphery?
Conventional wisdom emphasises the loss of price competitiveness over the first decade of monetary union. In this period, Germany kept its unit labour costs stable: wages rose in line with workers’ improvements in productivity.
By contrast, elsewhere – and especially in the periphery – unit labour costs increased, as shown in Chart 1. With the price of goods produced in the periphery rising relative to those produced in Germany, the periphery’s share of the European market contracted.
And intra-euro area trade imbalances grew as a result. This diagnosis leads to a clear remedy: to correct its external imbalances, the periphery must regain price competitiveness. In the GS European Economics team, we have estimated the real depreciation required to do so.
The results of our base case analysis (which assumes a return to full employment with no structural change to the economy) are shown in Chart 2.
The striking thing about these results is the magnitude of the real depreciations required. For the small and vulnerable peripheral countries (Greece and Portugal), a real depreciation of at least 50pc is needed relative to Germany to re-establish external sustainability.
And even for larger, richer countries (Spain and France), we look for real depreciations of 30pc plus. Within monetary union, the nominal exchange rate is no longer available as an adjustment mechanism. Real depreciations therefore require “internal devaluations”, that is, deflationary measures to drive down wages.
We view relative wage cuts of the magnitude implied by our base case as unfeasible. It is difficult to imagine either France accepting a one-third fall in living standards relative to Germany, or Germany accepting the sustained higher inflation that would allow France to regain competitiveness without wage cuts.
With wage and price adjustments of sufficient magnitude to correct imbalances seemingly impracticable on political grounds, does that imply that the euro area is doomed?
To avoid this conclusion, we need to identify alternative adjustment mechanisms that do not require wage adjustments of such a magnitude. First, real depreciation could be effected through nominal exchange rate changes.
This is the eurosceptic solution: it implies exit from the euro area and the re-introduction of national currencies.
Rather than a recipe for how to save the euro, it is a description of how to dissolve it. Second, uncompetitive economies could suppress domestic demand to contain imports and run with mass unemployment on an ongoing basis.
British experience in the 1920s (after Churchill’s decision to return Britain to the gold standard at its pre-war parity) suggests this will ultimately prove futile. Perpetual deflation is a prelude to dissolution of the euro area, rather than a means to avoid it.
Third, the uncompetitive peripheral countries could be subsidised on an ongoing basis by the more competitive surplus countries via a system of fiscal transfers.
Such mechanisms are quite normal in continental monetary unions: witness the transfers from wealthy New York to poorer West Virginia via the federal government in the United States.
Finally, countries can make structural changes to their economies, by shifting resources among sectors to produce a more balanced structure of production and spending.
The alternative estimates of the required real depreciation shown in Chart 2 illustrate this point. For example, were France to replicate the economic structure of the “best performers” among its European partners (admittedly, a big ask), a wage cut of less than 10pc relative to Germany would be sufficient to re-establish external sustainability.
Of course, in a market economy, this restructuring is prompted by relative price changes. But an ability to restructure will help to reduce the required internal devaluation to politically feasible levels.
With the institutional capacity to implement sufficient structural changes absent, in the smaller peripheral countries membership of the euro area is maintained at present via a combination of mass unemployment and continuing subsidisation.
But with social cohesion under threat and the institutional mechanisms and political support for a euro area-wide fiscal redistribution (as yet) lacking, the possibility of an exit in the future remains alive. Turning to the larger countries, here options are more limited.
A euro area without France would cease to be meaningful: de facto, we would see a reversion to a “greater Deutsch- mark”.
Just as in the smaller peripheral countries, the politics of perpetual mass unemployment are unfeasible. And France and Spain are just too large to subsidise on an ongoing basis – Germany is neither able nor willing to do so.
So there is no alternative but to implement a restructuring of these larger economies to reduce the needed real depreciation to a plausible level. But the nature of the restructuring needs to be tailor-made for the country concerned.
Spain’s problems stem from its property bubble: it borrowed too much from abroad to build houses that it did not need. (It is estimated that more than 700,000 properties are empty in Spain.)
Simply put, Spain needs to stop building houses and divert the resources released from residential construction to manufacturing and exports.
Export proceeds can then be used to pay down external debt. The good news is two-fold: Spain has largely stopped building houses, and its exports are growing rapidly.
But the bad news is that the adjustment costs associated with this economic restructuring are substantial. Spanish unemployment is the obvious manifestation of this.
While labour market reforms introduced earlier this year offer the prospect of less costly adjustment over time, experience elsewhere demonstrates that such reforms take several years to have an effect.
And with the banking sector under stress and euro securities markets segmented and underdeveloped, the required sectoral shift of capital remains problematic. Reflecting these adjustment costs and their macroeconomic implications, Spain’s economy is weak and vulnerable at present.
But, although it is scant consolation to the unemployed, there is a silver lining to this weakness: it is associated with a necessary restructuring that offers hope of a more balanced and competitive Spanish economy in the future. But, thus far, the adjustment required in France is less well advanced.
Like Spain, France needs to shift resources into the tradable sector in order to address its chronic external deficit.
But the French economy is subject to a different distortion: its public sector is too big. Public expenditure in France is 56pc of GDP, compared with 47pc in Germany.
The inherently domestic-oriented nature of government spending implies that France produces too few tradable goods relative to Germany, and therefore its external position is chronically weak.
In Spain, a spontaneous bursting of the housing bubble initiated the necessary restructuring of the economy. But in France, a conscious political decision is needed to cut public expenditure if the required transformation is to be set in train.
And the political obstacles to that decision are high. The French authorities increasingly recognise the need to improve French competitiveness and a number of policy initiatives have recently been launched to address the issue.
But, as yet, the deep restructuring of the economy and commitment to reduce the size of the state that are required to effect a fundamental change remain elusive.
Over the next year or so, France is unlikely to be subjected to the economic, financial and political pressures that have ultimately forced reform on Spain and the rest of the periphery.
While weak, our economic outlook for France does not imply a recession of the magnitude seen in Spain and Italy over the past year.
With the government sector so large, the French economy is less cyclical than elsewhere – government spending continues regardless, serving to stabilise the economy.
Domestic political pressure for change is therefore muted, especially as politically influential interest groups – including pensioners and public-sector unions – have a vested interest in the status quo. France also benefits from current easy financing conditions.
While France continues to be seen as part of “safe Europe” by asset managers, French government bonds will be supported and the banking system funded.
Holders of the ample liquidity currently available in the euro area seek assets with risk characteristics close to German Bunds, but offering a higher yield.
French government bonds fit the bill. As 10-year yields fall below 2pc, the French authorities are under little market pressure to pursue structural reform.
And in the shorter term – as the European Central Bank stands ready to inject further liquidity into the market via its new “outright monetary transactions” programme – we do not expect this situation to change dramatically.
Pressure from France’s European partners is also muted. With Germany politically hamstrung by the prospect of Federal elections next year, the last thing it needs is a financial and economic crisis in France. Germany is unprepared and unwilling to take the decisions required to stabilise the euro area in those circumstances.
And Italy and Spain are too preoccupied with their own challenges to make demands for reform in France. Over the coming 18 months, we therefore do not expect France to shift decisively towards the structural reform agenda required to make its position in the euro area sustainable over the medium term.
As a result, the euro area cannot move towards a more definitive resolution of its institutional, governance and economic problems.
Rather, with help from the ECB’s financial support measures, the European authorities will continue to buy time over the coming quarters, in an attempt to retain the option of seeking resolution in the future.
A combination of economic, financial and political factors therefore serves to reinforce our expectation that the euro area will continue to muddle through, rather than progress towards resolution.
Given the impact of the resultant uncertainties on confidence and spending, our macroeconomic forecasts consequently remain weak.
telegraph.co.uk
Deleveraging and fiscal consolidation are the immediate causes of this economic weakness. By reducing spending, both weigh heavily on real activity but both are also elements of a necessary adjustment.
The euro area entered the financial crisis needing to correct significant financial and economic imbalances: in this context, acting to strengthen both public and private balance sheets via consolidation and savings is necessary, not optional. At stake is the pace and efficiency of the unavoidable adjustment process.
The resulting “growth vs austerity” debate is not unique to the euro area: it is familiar across advanced economies, not least here in the United Kingdom.
Indeed, if treated as a single consolidated entity, the fiscal and external imbalances faced by the euro area are (in general) smaller than those seen in the US, the UK or Japan. Other things being equal, the challenge of adjustment should be more manageable.
But treating the euro area in such a consolidated way is, at least at the moment, merely a statistical exercise. It has no basis in economic or political reality.
Rather than benefiting from its (relative) collective strength, the euro area is only as strong as its weakest link. And, on various dimensions, that weakest link is weak indeed. What’s more, these weaknesses have proved to be self-reinforcing.
Where euro area countries have accumulated large macroeconomic imbalances, the viability of their continued use of the euro as their currency has come into question.
Once financial markets entertain doubts over whether membership of the euro area is sustainable, default and redenomination risks emerge, a country’s borrowing rates rise, markets segment and a vicious self-sustaining cycle of weaker growth and tightening financing conditions is set in train, which serves only to validate concerns about sustainability.
The Greek experience illustrates as much. In these circumstances, the painful but necessary adjustment at the area-wide level can become a catastrophic dislocation in vulnerable participating countries, threatening both social cohesion in the nation concerned and the integrity of the system as a whole.
Finding the means to correct macroeconomic imbalances is therefore crucial if the euro is to become a workable currency.
And countries’ external balances – the current account and external debt – are central in this respect. Why did these imbalances emerge in the periphery?
Conventional wisdom emphasises the loss of price competitiveness over the first decade of monetary union. In this period, Germany kept its unit labour costs stable: wages rose in line with workers’ improvements in productivity.
By contrast, elsewhere – and especially in the periphery – unit labour costs increased, as shown in Chart 1. With the price of goods produced in the periphery rising relative to those produced in Germany, the periphery’s share of the European market contracted.
And intra-euro area trade imbalances grew as a result. This diagnosis leads to a clear remedy: to correct its external imbalances, the periphery must regain price competitiveness. In the GS European Economics team, we have estimated the real depreciation required to do so.
The results of our base case analysis (which assumes a return to full employment with no structural change to the economy) are shown in Chart 2.
The striking thing about these results is the magnitude of the real depreciations required. For the small and vulnerable peripheral countries (Greece and Portugal), a real depreciation of at least 50pc is needed relative to Germany to re-establish external sustainability.
And even for larger, richer countries (Spain and France), we look for real depreciations of 30pc plus. Within monetary union, the nominal exchange rate is no longer available as an adjustment mechanism. Real depreciations therefore require “internal devaluations”, that is, deflationary measures to drive down wages.
We view relative wage cuts of the magnitude implied by our base case as unfeasible. It is difficult to imagine either France accepting a one-third fall in living standards relative to Germany, or Germany accepting the sustained higher inflation that would allow France to regain competitiveness without wage cuts.
With wage and price adjustments of sufficient magnitude to correct imbalances seemingly impracticable on political grounds, does that imply that the euro area is doomed?
To avoid this conclusion, we need to identify alternative adjustment mechanisms that do not require wage adjustments of such a magnitude. First, real depreciation could be effected through nominal exchange rate changes.
This is the eurosceptic solution: it implies exit from the euro area and the re-introduction of national currencies.
Rather than a recipe for how to save the euro, it is a description of how to dissolve it. Second, uncompetitive economies could suppress domestic demand to contain imports and run with mass unemployment on an ongoing basis.
British experience in the 1920s (after Churchill’s decision to return Britain to the gold standard at its pre-war parity) suggests this will ultimately prove futile. Perpetual deflation is a prelude to dissolution of the euro area, rather than a means to avoid it.
Third, the uncompetitive peripheral countries could be subsidised on an ongoing basis by the more competitive surplus countries via a system of fiscal transfers.
Such mechanisms are quite normal in continental monetary unions: witness the transfers from wealthy New York to poorer West Virginia via the federal government in the United States.
Finally, countries can make structural changes to their economies, by shifting resources among sectors to produce a more balanced structure of production and spending.
The alternative estimates of the required real depreciation shown in Chart 2 illustrate this point. For example, were France to replicate the economic structure of the “best performers” among its European partners (admittedly, a big ask), a wage cut of less than 10pc relative to Germany would be sufficient to re-establish external sustainability.
Of course, in a market economy, this restructuring is prompted by relative price changes. But an ability to restructure will help to reduce the required internal devaluation to politically feasible levels.
With the institutional capacity to implement sufficient structural changes absent, in the smaller peripheral countries membership of the euro area is maintained at present via a combination of mass unemployment and continuing subsidisation.
But with social cohesion under threat and the institutional mechanisms and political support for a euro area-wide fiscal redistribution (as yet) lacking, the possibility of an exit in the future remains alive. Turning to the larger countries, here options are more limited.
A euro area without France would cease to be meaningful: de facto, we would see a reversion to a “greater Deutsch- mark”.
Just as in the smaller peripheral countries, the politics of perpetual mass unemployment are unfeasible. And France and Spain are just too large to subsidise on an ongoing basis – Germany is neither able nor willing to do so.
So there is no alternative but to implement a restructuring of these larger economies to reduce the needed real depreciation to a plausible level. But the nature of the restructuring needs to be tailor-made for the country concerned.
Spain’s problems stem from its property bubble: it borrowed too much from abroad to build houses that it did not need. (It is estimated that more than 700,000 properties are empty in Spain.)
Simply put, Spain needs to stop building houses and divert the resources released from residential construction to manufacturing and exports.
Export proceeds can then be used to pay down external debt. The good news is two-fold: Spain has largely stopped building houses, and its exports are growing rapidly.
But the bad news is that the adjustment costs associated with this economic restructuring are substantial. Spanish unemployment is the obvious manifestation of this.
While labour market reforms introduced earlier this year offer the prospect of less costly adjustment over time, experience elsewhere demonstrates that such reforms take several years to have an effect.
And with the banking sector under stress and euro securities markets segmented and underdeveloped, the required sectoral shift of capital remains problematic. Reflecting these adjustment costs and their macroeconomic implications, Spain’s economy is weak and vulnerable at present.
But, although it is scant consolation to the unemployed, there is a silver lining to this weakness: it is associated with a necessary restructuring that offers hope of a more balanced and competitive Spanish economy in the future. But, thus far, the adjustment required in France is less well advanced.
Like Spain, France needs to shift resources into the tradable sector in order to address its chronic external deficit.
But the French economy is subject to a different distortion: its public sector is too big. Public expenditure in France is 56pc of GDP, compared with 47pc in Germany.
The inherently domestic-oriented nature of government spending implies that France produces too few tradable goods relative to Germany, and therefore its external position is chronically weak.
In Spain, a spontaneous bursting of the housing bubble initiated the necessary restructuring of the economy. But in France, a conscious political decision is needed to cut public expenditure if the required transformation is to be set in train.
And the political obstacles to that decision are high. The French authorities increasingly recognise the need to improve French competitiveness and a number of policy initiatives have recently been launched to address the issue.
But, as yet, the deep restructuring of the economy and commitment to reduce the size of the state that are required to effect a fundamental change remain elusive.
Over the next year or so, France is unlikely to be subjected to the economic, financial and political pressures that have ultimately forced reform on Spain and the rest of the periphery.
While weak, our economic outlook for France does not imply a recession of the magnitude seen in Spain and Italy over the past year.
With the government sector so large, the French economy is less cyclical than elsewhere – government spending continues regardless, serving to stabilise the economy.
Domestic political pressure for change is therefore muted, especially as politically influential interest groups – including pensioners and public-sector unions – have a vested interest in the status quo. France also benefits from current easy financing conditions.
While France continues to be seen as part of “safe Europe” by asset managers, French government bonds will be supported and the banking system funded.
Holders of the ample liquidity currently available in the euro area seek assets with risk characteristics close to German Bunds, but offering a higher yield.
French government bonds fit the bill. As 10-year yields fall below 2pc, the French authorities are under little market pressure to pursue structural reform.
And in the shorter term – as the European Central Bank stands ready to inject further liquidity into the market via its new “outright monetary transactions” programme – we do not expect this situation to change dramatically.
Pressure from France’s European partners is also muted. With Germany politically hamstrung by the prospect of Federal elections next year, the last thing it needs is a financial and economic crisis in France. Germany is unprepared and unwilling to take the decisions required to stabilise the euro area in those circumstances.
And Italy and Spain are too preoccupied with their own challenges to make demands for reform in France. Over the coming 18 months, we therefore do not expect France to shift decisively towards the structural reform agenda required to make its position in the euro area sustainable over the medium term.
As a result, the euro area cannot move towards a more definitive resolution of its institutional, governance and economic problems.
Rather, with help from the ECB’s financial support measures, the European authorities will continue to buy time over the coming quarters, in an attempt to retain the option of seeking resolution in the future.
A combination of economic, financial and political factors therefore serves to reinforce our expectation that the euro area will continue to muddle through, rather than progress towards resolution.
Given the impact of the resultant uncertainties on confidence and spending, our macroeconomic forecasts consequently remain weak.
telegraph.co.uk
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