Anxiety about Spain and Italy’s bond spreads has returned with a vengeance. In this dangerous race to the bottom, Italy was in lead position back in November but Spain has now overtaken it and is once again at the epicenter of the crisis. Spain’s macroeconomic imbalances are much larger than Italy’s, but, to grow again, both countries confront an enormous challenge in reorienting their economies towards exports and import-competing sectors.
There is no lack of ideas about what a growth policy for Spain, Italy and other troubled countries in the European periphery would look like. But most of these ideas misdiagnose the crisis as one of shortage of credit or demand and are false remedies. The Euro crisis is at its root not a fiscal or banking crisis, but a crisis of competitiveness hatched over about 15 years, and reflected in large differences in labor cost, export and balance of payments, between the periphery and the core, notably Germany. It is a crisis about the periphery’s inability to supply at reasonable cost, not primarily about a shortage of demand. It cannot be corrected just by increasing spending or injecting liquidity.
Fixing the competitiveness problem is now essential for growth. First, foreign markets and more specifically emerging markets are where the only big sources of growth are today, and the ability to compete in those markets is crucial. While according to the IMF, domestic demand in the periphery is expected to shrink by over 2% this year, and to be flat in the rest of Europe, it is likely to grow by over 5% in emerging markets and by over 2% in the United States and other advanced countries. Second, failure to regain competitiveness against Germany, Europe’s largest exporter by a huge margin, signifies that the Euro “Made in Germany” will remain simply too high for the periphery. Third, given current cost relations, domestic demand in the periphery cannot grow without increased foreign borrowing (a wider current account deficit), which has become essentially unavailable to the periphery.
How do Spain and Italy compare? Spain grew over twice as fast as Italy in the decade before the financial crisis, but largely on the back of a huge housing bubble. Italy’s productivity and demographics are also less propitious to growth. Spain’s subsequent housing bust has been as dramatic as its huge boom, and its macroeconomic imbalances – unemployment and fiscal deficit – as well as (probably) its banking troubles are now much worse than Italy’s. Even though Italy has larger government debt, Spain is much more externally indebted than Italy because of its large private sector debt, a result of the housing bubble. The significance of all this is that, to reignite sustainable growth, Spain has to make a bigger adjustment towards the traded sector than Italy does.
Both countries, however, have a lot of catching up to do. Between 1997 and 2007, their real effective exchange rate, based on unit labor costs in dollars appreciated by 11 percent and 9 percent in Spain and Italy, respectively, while Germany saw a depreciation of over 14 percent. This competitiveness loss was reflected in a shift away from exports and deteriorating current account balances, with Spain’s deterioration much more pronounced than Italy’s. For example, over the pre-crisis decade, exports as a share of GDP fell by 3.4 percentage points and 1 percentage point in Spain and Italy, respectively, but increased by a dramatic 20 percentage points in Germany. Meanwhile, Germany’s current account balance improved by 8 percentage points, while Spain and Italy’s deteriorated by 10 and 4 percentage points, respectively.
Unfortunately, there is little sign that these extraordinarily divergent trends are being reversed in Italy despite the deep decline in domestic demand. Spain has suffered an even deeper recession but is showing some signs of adjustment. Between 2007 and 2011, Spain’s real effective exchange rate based on unit labor costs depreciated by 4.4 percent, but, remarkably, Italy’s actually appreciated further, by 2.2 percent. Meanwhile, Germany’s real exchange rate was more or less stable even though domestic demand there held up much better. Not surprisingly, exports as a share of GDP increased by 3.2 percentage points in Spain, but hardly budged in Italy. Spain’s current account balance, moreover, improved by six percentage points of GDP, while Italy’s deteriorated further, by a percentage point.
Various other surveys tend to confirm that Spain and Italy have much work to do, though Spain does a little better. The World Bank’s latest Doing Business report, for example, ranked Spain 24 out of 31 advanced countries and Italy ranked 30th—just above Greece. These rankings score Germany much higher and have not changed much since the crisis hit. The World Economic Forum’s Global Competitiveness Index, also shows little change. Italy continues to receive very low marks for its infrastructure and macroeconomic environment, and both Spain and Italy rank abysmally low on labor market efficiency – 96 and 126 out of 134 countries, respectively.
Looking at trends over a longer period suggests that Spain is on a stronger export trajectory than Italy, though starting form a lower level. Spain has held on to its export share in world markets better than Italy. Between 1995 and 2011, Spain’s exports as a share of world trade fell from 1.9 percent to 1.6 percent, while Italy’s share declined much more sharply from 4.5 percent to 2.9 percent. As a share of total EU exports, Spain’s share has stayed steady since 2001 at just under 5 percent, but Italy’s dropped sharply from 10.1 percent to 8 percent.
Exports in both Spain and Italy, are less oriented towards Asia and China than they should be and less than that of Germany. But Spain’s exports remain even more Europe-centric than Italy’s. In 2011, roughly 3 percent of Italy’s exports went to China, while only 1.6 percent of Spain’s did. Asia as a whole (excluding Japan), moreover, accounted for 15 percent of Italy’s exports, but only a little over 9 percent of Spain’s. Spain’s exports are also less concentrated in manufactures, including high value-added manufactures, than Italy’s. In 2011, 61 percent of Spain’s exports consisted of machinery, transport equipment, and other manufactured goods, while 74 percent of Italy’s did, the same share as Germany.
In sum, neither Spain nor Italy look particularly well positioned to take advantage of an export-led recovery. Spain’s export prospects look better than Italy’s, but Spain also needs a bigger adjustment to correct its macroeconomic imbalances. This assessment is consistent with the latest IMF forecast, which shows Italy’s exports growing at just 1% in 2012, less than Germany’s and Spain, although all three countries are expected to continue rapidly losing share in world trade to emerging markets.
What to do? Spain and Italy can no longer devalue nor use independent monetary policy or trade policy. But they can undertake domestic reforms that make them more competitive and help them attract foreign investment. These range from easing regulations, increased competition among domestic suppliers in all sectors, incomes policy to moderate wages, tax policy that favors employment (reduction of payroll taxes) and discourages consumption (increasing VAT), infrastructure investments that facilitate trade, to trade and investment promotion. Some of these measures are difficult to execute and take time to work, but there is no realistic alternative to their determined pursuit. Tough austerity policies over many years are an inevitable part of the adjustment but should no longer be necessary once competitiveness is reestablished. Make no mistake: failure to reestablish competitiveness in the periphery means either a catastrophic Euro exit, or accepting decades of deindustrialization, depopulation and decline.