As the Commission’s President, Herman van Rompuy, said in a speech in Paris at the end of September, it has become fashionable lately to announce the imminent death of the EU. Not so, he proclaimed! Under the stronger guidance of the Commission, the brave convoy of 27 ships will sail on successfully. Despite such rhetorical flourishes, in the future the convoy may prove ever more difficult to navigate and may well end up on the rocks.[i]
Yes, Mr van Rompuy is right to say that having a monetary union without a budgetary [fiscal] union has been a handicap. Nevertheless, the Commission’s plan announced last week to levy substantial fines on Eurozone states failing to adhere strictly to the Stability and Growth Pact (SGP) reveals a fundamental misunderstanding of the economics of the problem. Enforced budgetary discipline, far from alleviating the Eurozone’s economic problems, will aggravate them. Why? Because lack of budgetary discipline did not cause the crisis.
It is conventionally assumed that the Eurozone crisis arose because Club-Med governments had been too profligate. If only they had been as cautious as northern European countries, the argument runs, they would have retained their export competitiveness. A recent carefully researched paper popularly known as the RMF report, compiled by academics at the University of London, SOAS, shows this argument to be entirely without foundation.[ii] The report’s conclusions have been strongly endorsed in a recent speech in Amsterdam by Keynes’s biographer, Robert Skidelsky.[iii]
But will there be another Eurozone upheaval? On balance, the answer is probably yes. In 2011, it is likely that we shall experience further debt crises in Greece, Portugal and Spain (the so-called Club-Med countries) and possibly even in Italy. Not only are these countries seriously indebted, but their government debt maturity structure is relatively short. That is only the beginning of the problem. Much of the Club-Med debt is private, and most of the overseas debt is owed to Eurozone banks.
In consequence, the creditor countries of the north, mainly Germany and France, will either need to bail out the Club-Med countries directly, or else they will need to bail out their own banks. Obviously, the creditor countries would prefer the debtors to tighten their belts than having to burden their own taxpayers.
The RMF report argues that at the root of the problem lies the trade imbalance between Germany and the Club-Med countries. Between 1999 and 2007, 70 percent of the growth of Germany’s GDP was accounted for by net exports. About two thirds of Germany’s trade surplus is with the rest of the Eurozone. Since Germany’s exports to the Eurozone are (by definition) someone else’s imports, Germany’s intra-Eurozone surplus is reflected in Club-Med deficits, as the following diagram taken from the report makes clear.
Selected Current Account Balances (% GDP)
Source: Lapavitsas et al, 2010, RMF Report, Fig 4.
Make no mistake: Germany has a highly skilled labour force and the quality of its exports is superb, but one of the reasons for Germany’s export success is that it has restrained domestic consumer demand by keeping real wages flat – over the past decade, real wage growth has fallen well behind the growth of labour productivity.
The other bit of the puzzle has to do with the relationship between Club-Med current account (external) deficits, government deficits and the countries’ total stock of debt. Once again, contrary to the prevailing view, Club-Med governments have not been wildly profligate: Greece, Spain and Portugal all have government deficits lower than the UK, and with the exception of Greece, their net public debt-GDP ratios are running at 60% or less.
Moreover, what is intriguing is that a substantial portion of Club-Med debt is held by the private sector: nearly 90% of all debt in Spain, 85% in Portugal and over 50% in Greece. Two things are important to note. First, less than half of all Spanish debt has been contracted abroad (in contrast to Portugal and Spain where the overseas proportion is much higher). Secondly, a far higher proportion of private debt is relatively short-term, meaning it will need to be refinanced sooner than much of the public debt.
How then does one explain why large current account (external) deficits have been run up in Club-Med countries if their governments have not been wildly profligate? To do so, it is vital to recall a basic national accounting identity. By definition, the external current account deficit is equal to the sum of the two domestic savings balances, private and public; ie, if the external deficit is not explained by public profligacy, it must then be explained by private profligacy.
Indeed, in Spain, private profligacy has mainly to do with a sharp rise in private investment corresponding to the housing boom. In Portugal and Greece, by contrast, private investment growth was much less important; in essence, private savings have contracted to finance rising consumer demand. Nor is there anything surprising in these patterns – until 2008, the UK experienced both a private housing boom and a private savings collapse to sustain consumer demand.
Moreover, in the Eurozone just as in the UK, cutting public spending will not remedy the situation. If anything, cutting public spending by enforcing the SGP in the Eurozone risks pushing countries back into recession, just like the vicious cuts in Ireland have done. As the economy contracts, more firms will go broke, more non-performing assets will appear on banks’ balance sheets and more bailouts will be needed. Part of the answer lies not in cuts, but in recycling export surpluses from north to south. But what private firm wants to invest in a country whose national income is collapsing?
The Commission’s latest recommendations include the notion that something must be done about export surpluses, albeit phrased in the vaguest and most general terms. But that is only part of the puzzle. Unless the Commission analyses the underlying structural imbalances in the Eurozone – as done so clearly in the RMF Report – and recognises that the Eurozone needs fundamental reform quickly, the euro project will sink. Mr Rompuy faces a far more difficult task ahead than he is willing to admit. But then too, perhaps the political elites of the rich north no longer much care!
[i] See: http://www.consilium.europa.eu/uedocs/cms_data/docs/pressdata/en/ec/116691.pdf.