American Pie in the Sky
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Nouriel Roubini
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20 July 2012
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NEW YORK – While the risk of a disorderly crisis in the eurozone is well recognized, a more sanguine view of the United States has prevailed. For the last three years, the consensus has been that the US economy was on the verge of a robust and self-sustaining recovery that would restore above-potential growth. That turned out to be wrong, as a painful process of balance-sheet deleveraging – reflecting excessive private-sector debt, and then its carryover to the public sectorimplies that the recovery will remain, at best, below-trend for many years to come.




Even this year, the consensus got it wrong, expecting a recovery to above-trend annual GDP growthfaster than 3%. But the first-half growth rate looks set to come in closer to 1.5% at best, even below 2011’s dismal 1.7%. And now, after getting the first half of 2012 wrong, many are repeating the fairy tale that a combination of lower oil prices, rising auto sales, recovering house prices, and a resurgence of US manufacturing will boost growth in the second half of the year and fuel above-potential growth by 2013.




The reality is the opposite: for several reasons, growth will slow further in the second half of 2012 and be even lower in 2013close to stall speed. First, growth in the second quarter has decelerated from a mediocre 1.8% in January-March, as job creationaveraging 70,000 a monthfell sharply.




Second, expectations of the “fiscal cliff” – automatic tax increases and spending cuts set for the end of this year – will keep spending and growth lower through the second half of 2012. So will uncertainty about who will be President in 2013; about tax rates and spending levels; about the threat of another government shutdown over the debt ceiling; and about the risk of another sovereign rating downgrade should political gridlock continue to block a plan for medium-term fiscal consolidation. In such conditions, most firms and consumers will be cautious about spending – an option value of waiting – thus further weakening the economy.



Third, the fiscal cliff would amount to a 4.5%-of-GDP drag on growth in 2013 if all tax cuts and transfer payments were allowed to expire and draconian spending cuts were triggered. Of course, the drag will be much smaller, as tax increases and spending cuts will be much milder. But, even if the fiscal cliff turns out to be a mild growth bump – a mere 0.5% of GDP – and annual growth at the end of the year is just 1.5%, as seems likely, the fiscal drag will suffice to slow the economy to stall speed: a growth rate of barely 1%.



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Fourth, private consumption growth in the last few quarters does not reflect growth in real wages (which are actually falling). Rather, growth in disposable income (and thus in consumption) has been sustained since last year by another $1.4 trillion in tax cuts and extended transfer payments, implying another $1.4 trillion of public debt. Unlike the eurozone and the United Kingdom, where a double-dip recession is already under way, owing to front-loaded fiscal austerity, the US has prevented some household deleveraging through even more public-sector releveragingthat is, by stealing some growth from the future.


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In 2013, as transfer payments are phased out, however gradually, and as some tax cuts are allowed to expire, disposable income growth and consumption growth will slow. The US will then face not only the direct effects of a fiscal drag, but also its indirect effect on private spending.



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Fifth, four external forces will further impede US growth: a worsening eurozone crisis; an increasingly hard landing for China; a generalized slowdown of emerging-market economies, owing to cyclical factors (weak advanced-country growth) and structural causes (a state-capitalist model that reduces potential growth); and the risk of higher oil prices in 2013 as negotiations and sanctions fail to convince Iran to abandon its nuclear program.




Policy responses will have very limited effect in stemming the US economy’s deceleration toward stall speed: even with only a mild fiscal drag on growth, the US dollar is likely to strengthen as the eurozone crisis weakens the euro and as global risk aversion returns. The US Federal Reserve will carry out more quantitative easing this year, but it will be ineffective: long-term interest rates are already very low, and lowering them further would not boost spending. Indeed, the credit channel is frozen and velocity has collapsed, with banks hoarding increases in base money in the form of excess reserves. Moreover, the dollar is unlikely to weaken as other countries also carry out quantitative easing.



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Similarly, the gravity of weaker growth will most likely overcome the levitational effect on equity prices from more quantitative easing, particularly given that equity valuations today are not as depressed as they were in 2009 or 2010. Indeed, growth in earnings and profits is now running out of steam, as the effect of weak demand on top-line revenues takes a toll on bottom-line margins and profitability.



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A significant equity-price correction could, in fact, be the force that in 2013 tips the US economy into outright contraction. And if the US (still the world’s largest economy) starts to sneeze again, the rest of the world – its immunity already weakened by Europe’s malaise and emerging countries’ slowdown – will catch pneumonia.



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Nouriel Roubini, a professor at NYU’s Stern School of Business and Chairman of Roubini Global Economics, was one of the few economists to predict the recent global financial crisis. One of the world’s most sought-after voices on its causes and consequences, he previously served in the Clinton administration as Senior Economist for the President’s Council of Economic Advisers, and has worked for the International Monetary Fund, the US Federal Reserve, and the World Bank.

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The First World’s Fiscal Follies

Jeffrey Frankel

19 July 2012






CAMBRIDGE – The world’s advanced economies remain divided over whether to strengthen budget balances in the short term or to use fiscal policy to promote recovery. Those worried about the short-run contractionary effects on the economy call the first optionausterity”; those concerned about long-term sustainability and moral hazard call it “discipline.”




Either way, the debate is akin to asking whether it is better for a driver to turn left or right; depending on where the car is, either choice might be appropriate. Likewise, when an economy is booming, the government should run a budget surplus; when it is in recession, the government should run a deficit.




To be sure, Keynesian macroeconomic policy lost its luster mainly because politicians often failed to time countercyclical fiscal policy – “fine tuning” – properly. Sometimes fiscal stimulus would kick in after the recession was already over. But that is no reason to follow a destabilizing pro-cyclical fiscal policy, which piles spending increases and tax cuts on top of booms, and cuts spending and raises taxes in response to downturns.




Pro-cyclical fiscal policy worsens the dangers of overheating, inflation, and asset bubbles during booms, and exacerbates output and employment losses during recessions, thereby magnifying the swings of the business cycle. Yet many politicians in the United States, the United Kingdom, and the eurozone seem to live by it. They argue against fiscal discipline when the economy is strong, only to become deficit hawks when the economy is weak.




Consider the positions taken over the last three decades by some American politicians.





In his 1980 campaign and again in 1981, a period of recessions, President Ronald Reagan urged immediate action to reduce the national debt.




In 1988, however, as the economy approached the peak of the business cycle, candidate George H.W. Bush was unconcerned about budget deficits, even though the national debt was rapidly approaching three times the level that it had been under Reagan. Read my lips: no new taxes,” Bush famously declared.




Predictably, Bush and the US Congress finally summoned the political will to raise taxes and rein in spending growth at precisely the wrong moment – in 1990, just as the US was entering a recession. Although the timing of the legislation was poor, the action was courageous: pay-as-you-go (PAYGO) budgeting rules and other reforms deflected government finances back onto a path that eliminated the budget deficit by the end of the decade.




But, three years later – at the start of the most robust recovery in American historyall Republican congressmen voted against President Bill Clinton’s 1993 legislation to maintain Bush’s spending caps, PAYGO, and tax increases. Even after seven years of strong growth, at the peak of the business cycle in 2000, with unemployment at record lows, George W. Bush based his 2000 campaign on a platform of large tax cuts.




After recovery from the 2001 recession had gotten underway, and the inherited budget surpluses had nonetheless turned to record deficits, the Bush administration pushed through a second round of tax cuts in 2003, and maintained a rate of spending growth that was triple the rate under Clinton. As Vice President Richard Cheney put it, “Reagan proved that deficits don’t matter.”




These policies were maintained for another five years, as another $4 trillion was added to the national debt. Predictably, when the worst recession since the Great Depression hit in 2007-2009, politicians were reluctant to launch an adequate fiscal response, owing to the huge deficits and debts that the government had already been running.




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Republicans suddenly re-discovered the evil of budget deficits. They opposed Obama’s initial fiscal stimulus in February 2009, and succeeded in blocking further efforts when its effects petered out two years later. In my view, the government spending cutbacks of the last two years are the most important reason why the economic recovery that began in June 2009 subsequently stalled in 2011.




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Here, then, are three generations of politicians who favored fiscal expansion during booms (1982-1989, 1992-2000, 2002-2007) and austerity during recessions (1980, 1981, 1990, 2008-09). A similar unfortunate cyclelarge fiscal deficits when the economy is already expanding, followed by fiscal contraction in response to a recession – has also been visible in the UK and the eurozone in recent years.

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Turning left every time the road goes right, and vice versa, is worse than switching policies randomly.


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But the pattern is understandable: when the economy is booming, there is no political support for painful spending cuts or tax increases. There is a hole in the roof, but the sun is shining.



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Then, when the thunderstorms roll in, sinners suddenly get religion and proclaim the necessity of reforming – just when it is most difficult to fix the problem.
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Historically, it used to be developing countries whose dysfunctional political systems produced pro-cyclical fiscal policies. Almost all of them showed a positive correlation between government spending and the business cycle from 1960 to 1999.
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But things have changed. About a third of emerging-market countries’ governments – including authorities in China, Chile, Malaysia, South Korea, Botswana, and Indonesia managed to reverse the historical correlation. They took advantage of the 2003-2007 boom to strengthen their budget positions, saving up for a rainy day. They were thus in a good position to use fiscal stimulus when the global recession hit them in 2008-2009.






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In fact, a majority of the governments that have pursued countercyclical fiscal policies since 2000 are in emerging-market or developing countries. They figured out how to achieve countercyclical fiscal policy during precisely the decade when so many politicians in “advanced countriesforgot.





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Jeffrey Frankel, a professor at Harvard University's Kennedy School of Government, previously served as a member of President Bill Clinton’s Council of Economic Advisers. He directs the Program in International Finance and Macroeconomics at the US National Bureau of Economic Research, where he is a member of the Business Cycle Dating Committee, the official US arbiter of recession and recovery.



Bank bondholders

Burning sensation

Taxpayers should not pay for bank failures. So creditors must

Jul 21st 2012    

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“THE only way to deal with moral hazard is to take out bank bondholders and have them shot,” says a hedge-fund manager. By “shot” he is not recommending actual executions, but saying that investors should suffer losses when the banks whose bonds they hold need rescuing. To date during the financial crisis this has been a rarity. Bondholders have been the Scarlet Pimpernels of financeinvestors who prove elusive every time a bank’s losses are divided up.

 

 

 

 

The era of impunity is coming to an end. In the short term some creditors of Spanish banks may be forced to suffer losses as a result of a planned euro-zone rescue of that country’s financial system.







Over the longer term regulators in Europe and America are rewriting rules to “bail inbondholders by converting debt to equity. These moves may have a far-reaching impact on the price banks pay to borrow, and thus on what they end up charging for credit. And the transition to a system designed to protect taxpayers from expensive bail-outs may be a bumpy one.
To understand how bank bondholders ended up in their privileged position, you need to look at the capital structure of banks. Imagine a cake of many layers, each representing the bank’s liabilities. At the very bottom is a thin sliver of costly equity.



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This is the money that a bank’s shareholders have put into the business. Next comes a layer of “hybrid” or “juniordebt that is supposed to pad out the equity layer but is made of somewhat cheaper ingredients. Above that come various layers of debt that make up the main body of the cake.



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The thickest slices are bank bonds, or “senior unsecured debt”, and bank deposits. The icing on top is its “secureddebt, such as covered bonds or other loans and derivatives, where creditors can grab hold of assets if their loan is not repaid.





Dessert storm




These layers serve two purposes. When money is collected by the bank it is first paid out to those in the upper tranches, usually as fixed-interest payments on deposits or bonds. If anything is left it trickles down to the shareholders. But when losses are incurred, bites are taken out of the cake from the bottom first. In return for taking a chunk of the profits in good times, shareholders get wiped out in bad times.




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This system worked very badly in the financial crisis. The first problem was that the equity layer was far too thin, and that banks were wary of imposing losses on holders of hybrid debt. There was not enough loss-absorbing capital in the banks to cope with the losses they incurred. So more equity had to be found.






The second problem was that this money tended to come from taxpayers. Senior bondholders were repaid in full in all but a handful of cases. Ireland is the most egregious example of a country plunging into debt in order to repay its banking system’s bondholders. This was partly for legal reasons: in many countries bank deposits and senior bank debt were in the same layer of the cake, so that one couldn’t take losses without the other also doing so, a politically unthinkable prospect. But the bigger reason was that regulators were terrified that if they imposed losses on bondholders they would cause a wave of panic across the financial system that would hit funding for all banks.





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The pendulum has now swung. This is evident in the Spanish bail-out, where euro-zone governments are reluctant to put their own taxpayers’ money at risk while seeing Spanish bondholders and holders of hybrid debt being repaid in full. Holders of the lowest layers of debt in bailed-out banks are likely to see their debt converted into equity and to take losses. This is particularly controversial in Spain, because many of the holders of this type of debt are unsophisticated retail customers: horror stories are emerging of illiterate customers signing up for risk-bearing debt with their thumbprints.





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Imposing losses on junior debtholders is one thing; trying to bail in senior bondholders is quite another. In a significant U-turn, the European Central Bank (ECB) has reportedly proposed imposing losses on bondholders in Spanish banks that collapse. That idea was rejected by European finance ministers because they worried it would spook markets.




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It is only a matter of time. In Britain, Switzerland and the European Union rules are either now in force or being drafted that will force banks to ensure that at least some of their debt can be turned into equity in a crisis.



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Some of this debt may take the form of convertible bonds that convert at a specific trigger-point: Credit Suisse issued SFr3.8 billion ($3.9 billion) of this sort of debt on July 18th. Most will be ordinary bank bonds that can be converted by the regulator. Rules empowering the Federal Deposit Insurance Corporation to take over failing American banks achieve much the same result.
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Yet imposing losses on bondholders risks unintended consequences. The first is that the cost of bank debt may rise a lot more than it has already. A decade ago big companies paid more to borrow than banks did. Now the opposite is true (see chart). This gap may widen further as investors price in the risk that governments will do all they can to avoid bailing out banks (although higher equity levels, the thicker bottom slice of the cake, also offer bondholders more protection from losses).




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A second risk is that senior bank creditors will respond to the potential for losses in a way that makes the system less stable. They may make sure their loans are secured—which in turn increases the losses inflicted on the remaining unsecured creditors and thus the price they will demand.



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Or they may plump for short-term debt so that they can pull their money out in a flash. Such dangers underpin the case for a gradual transition to a bail-in regime, but do not undermine its desirability. A world in which bank bondholders expect to get shot is one in which taxpayers are safer.



July 18, 2012 7:26 pm

Eurozone: In search of a driver

Will Germany’s cautious consumers lead the rebalancing of the continent’s economy?
 
 
 
 
For Tobias Geistert, there was never any question that more money was justified. Just looking at the price of petrol, it was obvious we needed a pay rise higher than inflation,” says the 24-year-old who builds engines for Mercedes-Benz in a Berlin factory.




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Together with 3.6m other workers in the German car industry and related engineering sectors – the backbone of Europe’s biggest economyMr Geistert received a big rise in May, even if it was not quite as high as union negotiators had demanded.No, we didn’t get 6.5 per cent,” he says. “But 4.3 per cent is good.”
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Relatively speaking the settlement, one of a series negotiated in the country’s leading industrial sectors, is more than good. Average wages in the crisis-hit eurozone in March were only 2 per cent higher than the year before. In Germany, on the other hand, the 2012 wage round is the best car workers have seen in two decadesduring which time employees endured more moderate real income growth than eurozone neighbours as industry and unions banded together to hold wages down to restore competitiveness. Such restraint delivered significant benefits, enabling exporters to sell more goods at lower prices.
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But there was a flipside. Wage restraint damped the enthusiasm of consumers, who spent much of the past decade or so conserving cash, registering savings rates among the highest in the world. That had wider consequences, leading German banks to recycle domestic savings into cheap loans to the booming economies of the eurozone, fuelling the current account deficits and credit bubbles that have blighted eurozone governments from Athens to Rome and Madrid.



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For that reason a consensus has emerged that to fix its economy Europe must “rebalance”. Southern states want German workers such as Mr Geistert to get out there and start spending on more eurozone products – while Germany calls on the peripheral countries to raise the competitiveness of their products, making them more attractive to German shoppers.





In fact, rebalancing is proving to be as much about German industry taking advantage of increasingly competitive eurozone products as it is about consumers.



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The country’semployment is strong, unemployment is low, wages are rising, so that bodes well for domestically oriented growth”, Subir Lall, the International Monetary Fund’s German mission chief, said this month. In its annual country report, the IMF notes, several of the elementsneeded for a rebalancing are now in place.



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The process is under way. In terms of goods, its trade surplus with the rest of the eurozone has fallen from almost 5 per cent of gross domestic product in 2008 to less than 3 per cent at the end of the first quarter. While this is in a part a result of declining consumption in the eurozone’s austerity racked south, imports from the region were up 5 per cent. Germans finally appear to be buying more goods. Market-research company GfK reported this year that 24 per cent were planning to travel more in 2012 than in 2011, with Italy and Spain favourite European destinations.





After years of resisting calls to stimulate consumption, Berlin has in recent months shifted ground. A number of Chancellor Angela Merkel’s ministers spoke out in favour of generous rises as this year’s pay talks started. The Bundesbank, the national central bank, also signalled it would be willing to tolerate a national inflation rate slightly above the eurozone target of 2 per cent.





At the same time, southern European companies were starting to profit from their own austerity measures, imposing wage restraints and welfare reforms. Italy exported 11 per cent more goods to Germany in the first quarter than a year before, and Spain registered a 4 per cent rise. The pull of German consumption was joined by the push of more competitive products from elsewhere.





But these headline figures disguise the fact that Mr Geistert and his compatriots are not the main drivers of German rebalancing. Though private consumption has risen, it is not booming. Indeed, shoppers seem more intent on putting money into inflation-proof savings vehicles – buying houses or apartments – than spending it on eurozone-made consumer goods.



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A leading driver of demand for eurozone imports is industry. The sector is buying capital goods to equip factories, as well as components to put in products such as cars and machines tools, which are still selling well outside the single currency area. Germany in the first quarter imported less Spanish olive oil and more Spanish car parts than in the same period in 2010 – a sign eurozone rebalancing is as dependent on the German exporter as on the German shopper.



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The country’s economic health bounced back from the global crisis more quickly than others in the eurozone, which spurred private consumers even before this year’s wage deals. Unemployment fell to a two-decade low in March, with 2.8m, or 6.7 per cent, out of work. First-quarter wages were 2.4 per cent higher than a year before. Private consumption generated half of the period’s 0.5 per cent growth.






Mr Geistert recalls that Mercedes-Benz employees received a €4,100 bonus earlier this year from parent company Daimler, which he spent on “another moped for my collection” and a washing machine. But he says the June rise will add a more modest €50 after tax to his and his colleagues’ monthly cheques. “I think most of the pay rise will be eaten up by the cost of living or be put into savings accounts,” he says.





The traditionally hesitant German consumer appears in no mood to change their behaviour. Holger Schmieding at Berenberg, a German bank, reckons the wage rounds could lift income by as much 3 per cent over the year. “But even if it turns out to be a bit higher, private consumption will rise by only 1 per cent, contributing maybe 0.5 per cent to a forecast gain in GDP [of 1 per cent]. That’s something. But it’s not a trend that will save Europe.”





An indication of consumers’ lingering hesitancy is rising demand for housing. Property prices rose 5.5 per cent last year, a stellar rate for a long stolid market. As Mr Schmieding notes: “Germans are buying and building and doing up houses” – a form of spending that usually boosts domestic building suppliers but does not directly help their eurozone partners.



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Klaus-Dieter Schwendemann is head of marketing at WeberHaus, a manufacturer of houses that cost up to €2m and whose components are sourced domestically, thereby not contributing to Germany’s trade balance. Years of decline in homebuilding bottomed out in 2009 and picked up in 2010, he says. “Construction permits rose 20 per cent to 103,000 in 2011 – a huge leap.”




The company, based in southwest Germany, built 700 houses last year, a rise of 14 per cent, and Mr Schwendemann expects to sell at least 725 this year, 90 per cent of them in Germany. From the start of the crisis, a remarkable number of buyers paid upfront in cash. “They were transferring assets from equities and savings into bricks and mortar to a degree that we’d never seen.”



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As Germany’s economy strengthened, the more traditional homebuyers reinforced demand. “Before 2009 people were worried about job security and the [high] levels of contract workers. Then sentiment turned,” he says. “Today, a young engineer has a career perspective and new confidence. Many young families are now looking to build.”



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That should further reduce the country’s dependence on exports and the vagaries of the world economy. Even as fears about poor global growth in the second quarter – that of China, in particularhave grown, some economists have raised their forecasts for Germany. The Bundesbank now expects the economy to grow 1 per cent, not 0.6 per cent, this year – if the global economy holds up.





But the country’s household spending ultimately seems to have little bearing on eurozone rebalancing. “I don’t think German private consumption – or even construction investment – is that decisive for the rebalancing of the eurozone,” says Andreas Rees at UniCredit. As well as welcoming capital investment by German companies, the eurozone should hope German exports will remain strong.



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“These contain the intermediate products which Germany is importing more of from the eurozone.”





Xavier Pujol agrees. He is chief executive of Ficosa, a car-parts manufacturer based in Barcelona, with 8,500 employees and €973m in revenues in 2011. Spain’s competitiveness has already risen, he says. “Our clients in Germany and France and elsewhere are taking this improvement in productivity into consideration.”




In the growth area of electronic systems, Ficosa felt strong enough to start a joint-venture with Sanyo, the Japanese electronics company, and Seat, the Spanish car brand owned by Germany’s Volkswagen, to make batteries for electric cars. More recently, we got a contract with Volkswagen to supply the battery management system for its planned electric vehicle, the e-Up,” he says.




With the Spanish economy shrinking, and reforms still being implemented, he is under no illusion about the tough path ahead. But his company’s renewed export successes offer a ray of hopeone ultimately based not on the wage rise Mr Geistert received but on the 6.5 per cent increase his union failed to win.



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Ultimately, says Mr Schmieding, the car workers’ 4.3 per cent offered everyone somethingconsumption and competitiveness. “It was a pay deal which was a bit too high when measured against productivity growth. But it was not too high to endanger the competitiveness of Germany’s companies – which is good news for Germany, and also for countries like Italy and Spain.”




That the unions like to keep an eye on the macroeconomic environment as much as their members’ wallets is well known on German shop floors. Mr Geistert wonders whether this made IG MetallGermany’s powerful carworkers’ union – “a bit too quiet” during the financial crisis when it came to pressing workers’ demands.




“But, looking back, it was the right thing to do,” he concedes. Can you imagine if we’d triggered a strike wave in or after 2009? We could have made the crisis worse – and longer.”



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Copyright The Financial Times Limited 2012.