The case against the euro
Travelling between Germany and Spain a disturbing question formed in my mind. Has the euro been not just bad for some countries but damaged them perhaps for a generation?
What prompted this thought was my reading of an in-depth analysis of the crisis in the eurozone. It has been put together by the Carnegie Endowment for International Peace. It is called Paradigm Lost - the Euro in Crisis. It features a series of reports by economists such as Uri Dadush, Sergei Aleksashenko, Vera Eidelman and Paola Subacchi.
They chart how the euro crisis started. The paper is rich in data, but even though it lacks characters it reads more like a financial novel. It is the story of a project that started with high hopes, huge ambitions, but which for some countries came crashing to Earth.
The focus of the report is the so-called PIIGS - Portugal, Ireland, Italy, Greece and Spain. Carnegie prefers to call them the GIIPS, but I will stick with the PIIGS. These are the countries most at risk from their high debt levels. The report compares their performance with that of the core countries in the euro, such as Germany. For brevity I will call them the euro core.
As the PIIGS adopted the euro they experienced an almost immediate windfall. There was a steep fall in interest rates. Bond yields tumbled and borrowing became less expensive. There was a spurt in growth. Some countries enjoyed surpluses. In retrospect it seems a golden period, but even early on seeds were being sown that would lead to crisis.
Easy money emboldened investors and consumers to increase spending and run up debts. Foreign capital flowed into the PIIGS. In several of these countries domestic demand exploded and house prices soared. Wages increased sharply.
In Greece, Ireland and Spain credit increased by an average of 155%, but in countries like Germany and the Netherlands, the core, it increased by only 27%.
The combination of lower borrowing costs and expanding domestic demand boosted tax revenues and governments were tempted to increase spending. The money was rolling in. So public spending per person in the PIIGS rose by an average of 76% between 1997 and 2007. That compares to just 35% in the euro core.
In Greece, for instance, government spending per capita rose by 140% in 1997-2008. Greece was awash with cheap capital. As the Carnegie paper points out, the growth in domestic demand "drove up prices in Greece relative to that of the euro area, increasing domestic labour costs and eroding Greek competitiveness."
That is one of the key conclusions of the paper. Since adopting the euro Greece, Ireland, Italy, Portugal and Spain have become increasingly uncompetitive. That and the slowdown in productivity is the heart of the crisis in the eurozone, rather than debt. Debt is a symptom.
Take Ireland. Before it joined the euro it was already prospering. Between 1990 and 1995 inflation and borrowing costs were close to German levels. Its GDP was already growing faster than other PIIGS. In the view of the report "the euro gave an unsustainable boost to an already booming economy". The supply of capital exploded, surpassing 200% of GDP by 2008. It had averaged 40% in the years before it joined the single currency.
Or take Spain: Since 2000 its hourly labour costs have consistently outpaced those of the euro core countries by more than 1%. Spain's unit labour costs have risen by more than 30% since 2000, while Germany's nominal wages have grown roughly in line with productivity.
Loans to Spanish households and non-financial corporations grew to more than 200% of GDP, double what they were in 1998. Much of this easy money financed a building boom. In 2006 Spain started more homes than the UK, Germany, France and Italy combined. In just 10 years house prices more than doubled. In the view of the Carnegie authors, Spain has suffered a loss of competitiveness since joining the euro.
It is a similar story with Italy. Since joining the euro its competitiveness has also declined sharply. Between 2000 and 2009 its wages rose 32%. In Germany wages kept pace with productivity. If Italy had wanted to be competitive it should have kept its wages flat over the past decade.
Then there is Portugal: lower interest rates led to a consumption boom. Household debt more than doubled. The current account deficit soared and labour productivity slowed.
All of these problems were building before the financial crash of 2008. What the downturn did was to "lay bare the fragility of the (PIIGS) post-euro growth model and exposed or underscored the unsustainable trends of their debts".
The PIIGS, however, were restricted in the tools they could use to fight a growing crisis. They were part of a monetary union. "Without control over interest rates (because they were in the euro), the PIIGS were limited in their ability to deal with the bubble," says the Carnegie report. The European monetary policy was too loose for countries like Spain and too tight for Germany.
The crash of 2008 led to a dramatic collapse in demand and the PIIGS were left with high levels of debt.
To escape the debt crisis they need growth, but that depends on being competitive and the PIIGS are struggling to improve their competitiveness without being in control of their exchange rates.
So what's to be done? According to the economists in the Carnegie report, the PIIGS will have to reduce their debts, which most are attempting to do with austerity packages. The debt-to-GDP ratio needs to be on a firm, downward path and to be stabilised within three years. The European Central Bank should maintain an expansionary monetary policy, which it is doing. The authors also believe the eurozone should embrace higher inflation, as it "will ease the necessary cuts in real wages". Germany should stimulate domestic demand. And the eurozone should actively pursue a weak euro. But there are real doubts as to whether all that will be enough.
Take Greece. The proposed cuts in spending amount to 11% of GDP. That is "massive" according to the Carnegie report and "represents more than annual government spending on defence, healthcare and education combined". With that level of contraction it is hard to see how Greece can grow and pay off its debts. Just to stabilise its debt ratio would require Greece to make a huge fiscal adjustment - perhaps 12% of GDP.
For Italy to reduce its debt it needs a balance of 4% of income above expenditure. As the country embraces an austerity package domestic demand is likely to decline or at best stagnate.
To recover competitiveness Spain will have to embrace a 6% wage cut across the board for three years.
So the price of staying within the euro straitjacket is that the PIIGS will have to cut wages and embrace wide-ranging reforms to boost productivity . Government will have to be smaller, more efficient. There is likely to be social tension. The challenge facing the PIIGS is this. If they are to grow and compete they will have to cut wages and reduce spending. Growth will be at best anaemic. Unemployment will remain high. They may escape the bullet, but the potential legacy of having joined the euro is hard times for a generation.