Source: Il Sole
As Italian and Spanish spreads decline, Europeans are breathing a big sigh of relief. But have we turned a corner? Is the end of the crisis really in sight? Unfortunately, the answer is no. High spreads on government bonds are a symptom and not a cause of the crisis. True recovery requires big structural shifts in the economies of the periphery toward exports and the tradable sector more generally—an adjustment that will require many years.
The underlying cause of this terrible crisis is not fiscal. At the outbreak of the global financial crisis, government debt to GDP ratios in the periphery countries were lower than when the euro was created (Portugal was an exception). Spain and Ireland’s public debt burdens were much lower than Germany’s; even today, Spain’s debt burden is lower than Germany’s. The fiscal mess in the UK—a non-euro member—is worse than the situations in many eurozone countries, but it can borrow at record low interest rates.
Nor are weak banking systems at the root of the crisis in the periphery. When the global financial crisis hit, for example, the Italian banking system was in much better shape than the French, German, or UK banking systems.Today’s fiscal and banking weaknesses, dangerous as they are, are a result of the crisis, not its primary cause.
The root cause of the euro crisis is the huge cumulative deterioration in the periphery’s competitiveness, which began in the mid-1990s as exchange rates were frozen, interest rates converged, and domestic demand accelerated. This led to a progressive reallocation of the periphery’s production factors toward non-tradable services and construction and away from exports and import substitutes. This, in turn, was reflected in large and widening current account deficits in the periphery and surpluses in the core.
This process could continue only so long as financial markets incorrectly believed that the periphery’s domestic-demand-based growth model was sustainable. But the global financial crisis triggered a change in sentiment that would have come along at some point anyway. Ironically, the crisis may have done Europe a favor by revealing a cancer that could have spread irremediably.
Look away from the sovereign spread, and the fact that the crisis will take many years to overcome stares you in the face. Spain’s unemployment rate is at 23 percent, Greece’s is roughly 20 percent, and Portugal’s is at almost 15 percent—and all three are headed for a deepening recession this year. Ireland is only a little better off. Italy’s unemployment picture is better, but its growth outlook is even worse, and it is still early in its adjustment.
With large fiscal contraction in store over the next two years, banks deleveraging, and consumers and investors scared, there is no possibility of growth coming from domestic demand in the foreseeable future.
The only route to growth now is by exporting or by substituting for imports—Spaniards buying more Spanish-made cars and fewer German ones. A quick panoramic look tells you that Greece is least capable of achieving this because it has no significant export sector except tourism; for that reason, Greece may have to leave the euro. Portugal is in only a slightly better position. Ireland has a big export sector based on pharmaceuticals and high-tech goods, funded and operated by foreign multinationals with deep pockets, so it has a real chance of reigniting growth. Spain has several competitive international firms, but its export sector is too small. And with truly enormous macroeconomic imbalances, its success in sparking growth is uncertain.
Italy, meanwhile, has a large and diversified manufacturing export base, and even though its public debt is greater, its imbalances are not nearly as large as Spain’s. I believe Italy can eventually have a trade-led recovery, but only if it can moderate its wages and prices, requiring fiscal austerity as well as a steady structural transformation over many years. Mario Monti’s government has gotten off to a very good start, but completing the marathon will require endurance, not just speed.
And it goes without saying that to complete the marathon, the runners will also need water and emergency assistance—liquidity from the European Central Bank and help from a big European/IMF Stability Facility if needed.
How will we know the crisis is ending? Not by looking at spreads. Nor even, I would dare say, by looking at whether Greece or Portugal remains in the eurozone. The end of the crisis will be heralded by a return to sustained growth that affords decent living standards and employment opportunities to all citizens.
This article was originally published in Italian in Il Sole.