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Rebalancing the Eurozone

WASHINGTON, DC – The eurozone crisis unfolded primarily as a sovereign-debt crisis mostly on its southern periphery, with interest rates on sovereign bonds at times reaching 6-7% for Italy and Spain, and even higher for other countries. And, because eurozone banks hold a substantial part of their assets in the form of eurozone sovereign bonds, the sovereign-debt crisis became a potential banking crisis, worsened by banks’ other losses, owing, for example, to the collapse of housing prices in Spain. So a key challenge in resolving the eurozone crisis is to reduce the southern countries’ debt burdens.

The change in a country’s debt burden reflects the size of its primary budget balance (the balance minus interest payments) as a share of GDP, as well as the difference between its borrowing costs and its GDP growth rate. When the difference between borrowing costs and growth becomes too large, the primary budget surpluses required to stop debt from increasing become impossible to achieve. Indeed, growth in southern Europe is expected to be close to zero or negative for the next two years, and is not expected to exceed 2-3% even in the longer term.

While not always evident from the headlines, an underlying cause of the eurozone crisis – and now an obstacle for growth in the south – has been the divergence in production costs that developed between the peripheral countries, notably the “south” (specifically, Greece, Spain, Italy, and Portugal) and the “north” (for simplicity, Germany) during the first decade after the introduction of the euro. Unit labor costs in the four southern countries increased by 36%, 28%, 30%, and 25%, respectively, from 2000 to 2010, compared to less than 5% in Germany, resulting in an end-2010 cumulative divergence above 30% in Greece and more than 20% in Portugal, Italy, and Spain.

Unit labor costs reflect compensation levels and productivity: gains in productivity can offset the effect of wage growth. Productivity performance did not vary dramatically between northern and southern European countries from 2000 to 2010 – in fact, average annual productivity growth was faster in Greece than in Germany (1% versus 0.7%). But labor costs increased much faster in the south, resulting in differential cost increases that cannot be addressed by devaluation as long as the monetary union endures.

As long as this internal divergence persists, the euro crisis cannot be fully resolved, because current-account deficits and/or slow growth will continue to stalk the southern European countries, perpetuating worries about sovereign debt and commercial banks.

In this context, productivity growth – whether through technical progress, better allocation of resources, or productive investment – is as important a variable for the southern economies as wage restraint is. Indeed, excessive wage deflation is likely to have negative effects on productivity. Skilled labor is likely to emigrate faster, and extreme austerity, falling prices, and high unemployment – and the resulting likelihood of social tension – are not exactly conducive to investment, innovation, or labor mobility.

Likewise, while reducing employment is one way to boost productivity, it implies high macroeconomic costs in terms of lost revenues and higher social spending. Perhaps even more importantly, economic policy should not break a society’s confidence in itself; what economists call “animal spirits” must be able to reflect hope for the future.

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For all of these reasons, excessive austerity and deflation could defeat its own purpose and make the “reforms” to improve the southern European countries’ competitiveness impossible to implement. The right approach must combine reasonable wage restraint and low (but not negative) inflation with microeconomic policy measures aimed at encouraging productivity increases.

Moreover, it is clear that northern European countries could help to close the competitiveness gap more rapidly by encouraging faster wage growth. Indeed, Western policy-makers’ strong focus on persuading the Chinese authorities to permit greater appreciation of their currency is puzzling when one considers that Germany’s current-account surplus, as a share of GDP, is now much larger than China’s.

Reversing the large differential in unit labor costs that has emerged in the euro’s first decade thus requires not only wage restraint and productivity-enhancing reforms in the south, but also higher wage gains in the north. A simulation shows that if German wages grew at 4% annually instead of the 1.5% of the last decade, and if annual productivity growth in Spain accelerated to 2% (it was close to 0.7% in both countries), Spain could reverse the unit-labor-cost differential that emerged with Germany since 2000 in five years, with Spanish wages growing at about 1.7% per annum.

This should not be an impossible scenario. It would require restraint in Spain, where wages grew at an average annual rate of 3.4% in 2000-2010, as well as a serious effort to accelerate productivity growth. But it would not require falling wages or significant price deflation: annual wage growth of 1.7% and productivity growth of 2% would be compatible with inflation close to zero. Productivity growth at the historical rate of 0.7% in Germany, with wage growth of 4%, would be compatible with an inflation rate a little above 3%.

In short, internal adjustment in the eurozone is achievable without serious deflation in the south, provided that productivity growth there accelerates, and that the north does its part by encouraging modestly faster wage gains. The smaller current-account surplus in northern Europe that might result from this should itself be welcome. If the north insists on maintaining the low wage growth of the 2000-2010 period, internal adjustment would require significant unemployment and deflation in the south, making it more difficult and perhaps politically impossible to achieve.

Copyright Project Syndicate 2012

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