Economics focus
All pain, no gain?
In a single currency it is hard to become more competitive and repay your debts
Dec 9th 2010 | from PRINT EDITION
BY OFFERING partial bail-outs to countries in the euro area, the authorities are buying time. Time for what? The hope is that over a few years the indebted economies on the continent’s periphery, such as Ireland and Greece, will be able to restore their competitiveness. That would boost their exports and output, helping them to close their fiscal and current-account deficits. Just how realistic is this hope?
Competitiveness is usually taken to mean keen prices: if the price of cars produced in one country falls, foreign demand for them expands. In a monetary union, with the nominal exchange rate irrevocably fixed, it is not possible to gain competitiveness by currency depreciation. The only way is to reduce costs, relative to countries inside and outside the currency area. Economists sometimes refer to this as a “real depreciation” or “internal devaluation”.
That requires slower price and wage growth or faster productivity growth than elsewhere. Given today’s low inflation rates, it means outright declines in prices and wages.
In the decade and a half before the crisis, countries such as Greece, Ireland, Portugal and Spain lost a lot of competitiveness. Low interest rates led to a surge in domestic demand. That, coupled with rigid labour markets in some places, led to sharp rises in nominal wages. At the same time productivity growth was not vigorous enough to compensate. By contrast, for a decade after its reunification boom turned sour in the mid-1990s, Germany took bitter medicine, holding wages down and boosting productivity. The result was a steady erosion of the peripheral countries’ competitiveness, especially relative to Germany (see chart).
Somehow the peripheral economies have to reverse this trend. Their reform packages are designed in part to improve productivity: Greece, for example, is trying to cut red tape and break its monopolies. But much of the task lies in reducing wages and prices. Some countries’ efforts seem to be working. In Ireland, labour costs have fallen for two years and inflation has been negative for more than one. Public-sector pay packets are up to 15% lighter and will be lighter still after this week’s budget.
In Greece, however, the picture is less clear. Wages are heading down. But other costs are not falling. The country’s inflation rate, at 5%, is still well above Germany’s, although part of that differential is due to increases in value-added tax. Spain and Portugal, meanwhile, are only slowly waking up to the severity of their competitiveness problems. Even now inflation in these countries remains above the average for the euro area.
Will shock therapy help to restore competitiveness in these countries? There are three big hurdles. The first is history. Under the gold standard, countries used price and wage deflation as a means of adjusting to trade deficits. But a new study by the World Bank* suggests reasons for pessimism, at least in modern economies. Looking at the experiences of 183 countries between 1980 and 2008, it does not find many episodes of sustained deflation.
Argentina provides a telling example. Like the peripheral euro-area countries, it lost competitiveness during the ten years after 1991 when the peso was fixed to the dollar. It endured three years of deflation before its economy and dollar peg collapsed in 2001. The CFA (African Financial Community, formerly French Community of Africa) franc zone supplies another cautionary tale. Median inflation from 1986 to 1993 was 0.3%, and several countries experienced outright deflation towards the end of this period. But this failed to restore competitiveness, and there was a large devaluation in 1994.
A more encouraging conclusion can be drawn from Estonia, Latvia and Lithuania. All three Baltic countries pegged their currencies to the euro in the early to mid-2000s: they enjoyed booms, then lost competitiveness and were hit by the crisis in 2008. Output collapsed but they maintained their pegs and introduced austere policies. They are now showing tentative signs of recovery, based on exports. Anders Aslund† of the Peterson Institute reckons that their resolve reflected the fear among the public and officials that the sovereignty of these newly independent countries could be threatened. It also helped that their economies were so open: this forced them to respond quickly, as Ireland has had to do.
Right, let’s start making luxury cars
The second reason to be wary is that the chances of reviving exports also depend on the type and quality of goods a country makes and who its competitors are. Not everyone can be Germany, excelling at selling capital equipment and luxury cars, not least to booming emerging economies: this month Mercedes said its sales in China in the first 11 months of 2010 were more than double those in same period last year. This market position is extremely hard to replicate. For peripheral countries that specialise in lower-tech industries, China is less an export opportunity and more a competitive threat (see chart).
The worry is that such countries depend on selling commoditised products of which they may never be the cheapest producers.
The last problem for peripheral countries trying to deflate their way to competitiveness is the biggest: debt. The more wages and prices fall, the bigger debt burdens become in real terms. If the economy continues to shrink—nominal GDP dropped by about 30% in Latvia and has fallen by 20% in Ireland—there will be less money to service debts. This is the trap that Europe’s peripheral countries are in. They must become more competitive in order to export, grow and ease their debt burden. But the more they lower wages and prices, the harder that burden is to bear. As Irving Fisher noted almost 80 years ago, the struggle to reduce debts can sometimes increase indebtedness.
Competitiveness is usually taken to mean keen prices: if the price of cars produced in one country falls, foreign demand for them expands. In a monetary union, with the nominal exchange rate irrevocably fixed, it is not possible to gain competitiveness by currency depreciation. The only way is to reduce costs, relative to countries inside and outside the currency area. Economists sometimes refer to this as a “real depreciation” or “internal devaluation”.
That requires slower price and wage growth or faster productivity growth than elsewhere. Given today’s low inflation rates, it means outright declines in prices and wages.
In the decade and a half before the crisis, countries such as Greece, Ireland, Portugal and Spain lost a lot of competitiveness. Low interest rates led to a surge in domestic demand. That, coupled with rigid labour markets in some places, led to sharp rises in nominal wages. At the same time productivity growth was not vigorous enough to compensate. By contrast, for a decade after its reunification boom turned sour in the mid-1990s, Germany took bitter medicine, holding wages down and boosting productivity. The result was a steady erosion of the peripheral countries’ competitiveness, especially relative to Germany (see chart).
Somehow the peripheral economies have to reverse this trend. Their reform packages are designed in part to improve productivity: Greece, for example, is trying to cut red tape and break its monopolies. But much of the task lies in reducing wages and prices. Some countries’ efforts seem to be working. In Ireland, labour costs have fallen for two years and inflation has been negative for more than one. Public-sector pay packets are up to 15% lighter and will be lighter still after this week’s budget.
In Greece, however, the picture is less clear. Wages are heading down. But other costs are not falling. The country’s inflation rate, at 5%, is still well above Germany’s, although part of that differential is due to increases in value-added tax. Spain and Portugal, meanwhile, are only slowly waking up to the severity of their competitiveness problems. Even now inflation in these countries remains above the average for the euro area.
Will shock therapy help to restore competitiveness in these countries? There are three big hurdles. The first is history. Under the gold standard, countries used price and wage deflation as a means of adjusting to trade deficits. But a new study by the World Bank* suggests reasons for pessimism, at least in modern economies. Looking at the experiences of 183 countries between 1980 and 2008, it does not find many episodes of sustained deflation.
Argentina provides a telling example. Like the peripheral euro-area countries, it lost competitiveness during the ten years after 1991 when the peso was fixed to the dollar. It endured three years of deflation before its economy and dollar peg collapsed in 2001. The CFA (African Financial Community, formerly French Community of Africa) franc zone supplies another cautionary tale. Median inflation from 1986 to 1993 was 0.3%, and several countries experienced outright deflation towards the end of this period. But this failed to restore competitiveness, and there was a large devaluation in 1994.
A more encouraging conclusion can be drawn from Estonia, Latvia and Lithuania. All three Baltic countries pegged their currencies to the euro in the early to mid-2000s: they enjoyed booms, then lost competitiveness and were hit by the crisis in 2008. Output collapsed but they maintained their pegs and introduced austere policies. They are now showing tentative signs of recovery, based on exports. Anders Aslund† of the Peterson Institute reckons that their resolve reflected the fear among the public and officials that the sovereignty of these newly independent countries could be threatened. It also helped that their economies were so open: this forced them to respond quickly, as Ireland has had to do.
Right, let’s start making luxury cars
The second reason to be wary is that the chances of reviving exports also depend on the type and quality of goods a country makes and who its competitors are. Not everyone can be Germany, excelling at selling capital equipment and luxury cars, not least to booming emerging economies: this month Mercedes said its sales in China in the first 11 months of 2010 were more than double those in same period last year. This market position is extremely hard to replicate. For peripheral countries that specialise in lower-tech industries, China is less an export opportunity and more a competitive threat (see chart).
The worry is that such countries depend on selling commoditised products of which they may never be the cheapest producers.
The last problem for peripheral countries trying to deflate their way to competitiveness is the biggest: debt. The more wages and prices fall, the bigger debt burdens become in real terms. If the economy continues to shrink—nominal GDP dropped by about 30% in Latvia and has fallen by 20% in Ireland—there will be less money to service debts. This is the trap that Europe’s peripheral countries are in. They must become more competitive in order to export, grow and ease their debt burden. But the more they lower wages and prices, the harder that burden is to bear. As Irving Fisher noted almost 80 years ago, the struggle to reduce debts can sometimes increase indebtedness.
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