Friday, June 27, 2014

The eurozone is no place for poor countries

The economic rationale for poorer countries joining the eurozone was that it would hasten economic convergence between themselves and the richer members of the currency union. They would benefit from a stable macroeconomic environment and more trade and inward investment. And Portugal aside, there was some convergence in the early years of the single currency. But this went into reverse in 2008 and by 2013 the poorer members of the currency union were no better off relative to the EU-15 average than they had been in 1999. Worse still, they have been overtaken by a number of the 2004’s EU intake, who in 1999 had been much poorer. Has the euro become a mechanism for divergence? If so, what are the implications for growth across the eurozone as a whole and for the case for joining?

In 1999, Greek and Portuguese per capita GDP were around 70 per cent of the EU-15 average, and Spanish a little over 80 per cent. By 2013, Greek and Portuguese GDP was under 70 per cent of the average. Spain has not done quite as badly, but has been diverging since 2008 (see chart 1). Indeed, far from converging with the richer members of the EU, they have converged with the Central and Eastern European countries which joined the EU in 2004. In 1999, the GDP levels in Poland and Slovakia (a euro member since 2009) were 42 per cent and 43 per cent of the EU-15 average respectively. The Czech Republic’s was just over 60 per cent of the average. By 2013, these figures were 65 per cent, 72 per cent and 75 per cent.

Chart 1: GDP per capita


Source: European Commission

For crude supply-siders, the lack of convergence between members of the eurozone reflects the failure of the poorer member-states to push through reforms of their economies rather than anything to do with the structure of the currency union. This has cost them competitiveness, leading to economic stagnation.

Others maintain that divergence since 2008 is cyclical and will be quickly reversed. According to this view, the South is simply going through what Germany went through in the early 2000s. Interest rates are too high for the periphery in much the same way as they were for Germany between 1999 and 2006; conversely, they are now too low for Germany. Germany will grow more rapidly than the south for the next few years, but that will then reverse as Germany loses competitiveness and finds itself in similar position to that of the periphery now – with an overvalued real exchange rate and excessively tight monetary policy. At that point there will be renewed convergence between rich and poor. The worst that can be said is that the eurozone has amplified business cycles, but not that it has become an obstacle to convergence between rich and poor.

There are problems with both these arguments. First, it is hard to ascertain a correlation between the kinds of structural reforms the Commission is demanding of the South (principally labour market deregulation) and economic growth. Some of the best performing European economies over the last 20 years – notably Sweden and Austria – have relatively highly regulated labour markets. Germany – the benchmark for much of the Commission’s thinking – also has a tightly regulated labour market (notwithstanding 2004’s Hartz IV reforms), at least in regards to permanent workers (see chart 2). There is certainly a case for labour market reforms to address insider/outsider problems and to help young people and those with poor skills into work. But it is important not to exaggerate the economic effects of such reforms.

Chart 2: OECD indicators of employment protection legislation, 2013
(0 = least restrictions, 6 = most restrictions)

Source: OCED

Nor can differences in product market regulation explain the lack of convergence in living standards within the eurozone. First, according to the Organisation for Economic Co-operation and Development (OECD), there has been steady convergence of such regulation among EU member-states. Second, there is no discernible correlation between levels of product market liberalisation and economic growth. For example, Sweden has among the more tightly regulated product markets in the EU, while Germany and Italy score about the same as each other. Greece does rank badly, but only as badly as Sweden did five year earlier (see chart 3).

Chart 3: OECD indicators of product market regulation
(0 = least restrictions, 6 = most restrictions)

Source: OECD

This is not to say that – all other things being equal – competitive product markets will not boost economic performance, only that they can be more than offset by other things such as the wrong macroeconomic policies or misalignments of real exchange rates. The latter can have a big impact on levels of capital stock per employee and labour skills, which are more important in determining economic performance than levels of labour and product regulation. Cuts in education spending, large-scale emigration of young skilled workers and huge falls in business investment have damaged the productive capacity of the eurozone’s poorer economies.

The cyclical argument for the lack of convergence is also weak. There are several differences between Germany’s position in the early years of the euro and the south now. Germany’s period of retrenchment within the euro was essentially over by 2006. Germany’s real effective exchange rate was not seriously overvalued to start with. Germany was aided in its drive to reduce its real exchange rate by inflation being relatively high elsewhere in the eurozone. And, finally, the country was not highly indebted.

By contrast, the retrenchment in the poorer members of the eurozone has already lasted longer than in Germany in the early 2000s, and there is no end in sight for a number of reasons. First, their loss of trade competitiveness relative to the core is far bigger. Second, they are trying to regain competitiveness by holding inflation rates below the eurozone average at a time when inflation is chronically low elsewhere in the eurozone (German inflation is around 1 per cent and forecast to remain low). And third, they have very high levels of debt. Their drive to improve competitiveness is pushing them into deflation, increasing the real value of their debts and making it harder to deleverage.

As a result, overall levels of indebtedness in Greece, Portugal and Spain are still close to their all-time highs. Their levels of private sector debt have fallen, but there has been an offsetting increase in public debt. According to Standard and Poor’s, the so-called leverage ratio (public and private debt as a share of GDP) in Greece, Spain, and Portugal is currently around twice what it was at the beginning of 1999; Italy’s is 35 per cent higher.

Reducing these leverage ratios will be hard. Firms and households will continue to pay down debt for a long time to come, depressing consumption and investment. For their part, poorer eurozone governments risk contributing to the weakness of demand by continuing their drive to consolidate public finances. The result threatens to be weak economic growth and inflation and hence slow deleveraging. This is less a cyclical issue than a semi-permanent state of affairs. Growth in the poorer states will at some point in the future exceed that of the wealthier North, but any convergence is likely to be slow because of the permanent damage done to their growth potential.

A combination of debt write-offs, co-ordinated eurozone fiscal stimulus and a concerted drive by the European Central Bank (ECB) to drive up eurozone inflation could head off this unfavourable outcome. Anything is possible, of course, but all of these things look unlikely. Low borrowing costs have reduced pressure for institutional reforms of the eurozone, even if low bond yields should be ringing alarm bells (reflecting as they do mounting deflationary pressures). The eurozone might agree an investment programme, but a big fiscal stimulus is impossible without rewriting the rules. And there is little chance the ECB is going to morph into a European version of the US Federal Reserve and launch a full-blooded battle against deflation.

The fate of poorer EU-15 members of the eurozone should give prospective eastern and south-eastern EU member-states pause for thought before joining. They should also closely monitor the experience of Slovenia and Slovakia, which joined the single currency in 2007 and 2009 respectively. Slovenia is considerably poorer relative to the EU-15 average than when it joined. Slovakia has performed respectably within the single currency, but its real effective exchange rate has risen steeply relative to its peers (Czech Republic and Poland) and it has slipped into deflation.

For some – Lithuania, for example – joining the euro is about guarding its independence against a revanchist Russia. But the others face a trade-off: join the euro and get a seat at the top table (more and more of the real decisions on economic issues are taken by eurozone countries rather than the EU) in return for a loss of policy autonomy and much increased economic risk. Or reiterate their commitment to join but postpone doing so in the hope that the eurozone is reformed in such a way that it becomes a mechanism for convergence rather than divergence. This is the strategy being successfully pursued by Poland and the Czech Republic. Others would be wise to follow suit.

Simon Tilford is deputy director at the Centre for European Reform.


Quentin Davies said...

Simon Tilford's piece entitled "The Eurozone is no Place for Poor Countries" (27 June) is a full-throttled attack on the decision of poorer EU countries to join the system, and in effect on the whole euro project. In Tilford's view the euro has "become a mechanism for divergence", has "amplified business cycles", induced "wrong macroeconomic policies" and produced "misalignments of real exchange rates". The reader is left wondering whether there are any economic ills for which the euro is not responsible.

Tilford's Chart 1, demonstrates quite clearly that all the "poor" EU countries in the chart, euro members and non-euro members, were converging on the "EU 15 average" until the recession, with the best performances being registered by two euro participants (Greece and Spain) and two - at that time - non-participants (Poland and Slovakia). In other words there is no obvious correlation between performance and euro membership in the pre-recessionary period. Thereafter three "poor" countries, Greece, Spain and (to a much slighter extent) Portugal have diverged negatively, but only Greece is in a worse position relative to the "EU 15" at the end of Tilford's chosen 15 year period than at its outset. Most "poor" EU countries in the chart retained a more or less stable relative position during the recession years. Three of the countries included in Tilford's chart were in a markedly better relative position despite the recession at the end of that period (2013): Germany, Slovakia and Poland. In other words the countries whose growth rates were significantly different from the EU15 average over the 2009-2013 period and who appear in the chart, were one very problematic "poor" euro participant (Greece), which of course diverged negatively,and, in the positive category, one successful "poor " non-euro participant (Poland), one successful "poor" euro participant (Slovakia, which joined the euro in 2009), and one successful "rich" euro participant (Germany) all of which improved their relative positions.

That is hardly a sufficient basis from which to draw any general conclusions relating to euro membership, let alone the conclusion that euro membership inhibits good economic performance, whether for "poor" countries or for all countries, whether in normal conditions or in periods of recession . It becomes especially difficult to draw the negative conclusions about the euro which Tilford appears to have drawn if one looks at his own data for Slovakia and the Czech Republic (the latter not a euro participant). It is clear from his chart that Slovakia has been able to complete the process during the recession years, and after she joined the euro in 2009, of converging from a level of qualitatively greater poverty to virtual equality with the Czech Republic - an achievement that had eluded Slovakia under every previous regime since, and including, the Austro-Hungarian Empire. Given these two countries' common history until this point, their combined experience probably gets as close to a controlled experiment as it is possible to get in empirical macroeconomics.

Quentin Davies said...

Part 2: If Tilford's chart fails to support his conclusions, would his argument be helped by extending his trawl and looking at the record of other euro-participating states? The answer is no. Tilford left two "poor" euro-participating states, who have been euro participants for more than six and three years respectively, out of his chart: Malta and Estonia. Perhaps he thought they were too small, but he does not explain why size should be considered a critical variable in this context (and Greece and Portugal are hardly large). In any event Malta and Estonia go against the Tilford rule - both have done better than the EU15 average since they joined the euro, and have therefore converged.

The clue to the solution is to look at the performance of the EU 15 themselves (only one of which, Germany, is included in Tilford's chart). The worst performers in this group by far were Italy and Ireland. What unites Italy, Ireland, Greece, Spain and Portugal - the worst performers in the two groups ("poor" and "rich")? The answer is debt. These countries had the highest leverage ratios in the EU, among euro participants and non-participants. Their poor performance in a recession is no more surprising than would be a table showing that the earnings (and share prices) of highly leveraged firms under-perform in a recession. If the problem of under-performance in these countries is a problem of debt then debt itself - not the euro - is the "wrong macroeconomic policy" which has produced the evils of "divergence", "amplified business cycles" and (because of the loose spending of the debt proceeds) the"misalignments of real exchange rates" of which Tilford rightly complains,

Tilford recognises that debt is the serious problem we now confront but speaks of it as a consequence and an inheritance we now face not a cause. "Firms and households will continue to pay down debt for a long time ...depressing consumption and investment...governments risk contributing to the weakness of demand by continuing their drive to consolidate public finances. The result threatens to be weak economic growth." He may be over-pessimistic on the timing (British households have begun quite quickly after 6 years of recession and flat-lining to reduce their savings ratio and to generate a consumer-led revival of growth up to or above trend level and we all hope that business investment will flow from that). But clearly the whole of Europe (and the US) suffered from quite egregiously irresponsible levels of borrowing (and lending practices) at the end of the last decade,and in some countries the impact was dramatic. Whether the error was excessive borrowing by governments when spreads were compressed in a mad scramble for yield as interest rates fell (Portugal and Greece), or crazy lending to the real estate sector (Spain, Ireland and sub-primes and CDOs in the US), the cost has been felt by every citizen. Of course Greece was a special case because there the public accounts were actually falsified and the borrower must assume a large part of the blame (and hopefully criminal liability). Elsewhere lenders, fund managers and underwriters, who are supposed to deliver lending discipline, had no such excuse - there was simple massive mis-pricing of risk. Was this caused by short-term bankers' bonuses, conflict of interest, other dishonesty or sheer incompetence? Were supervisors and regulators asleep, or just not up to the job? We have no final answer to these questions.

Quentin Davies said...

Part 3:

Some people will blame the borrowers, some people will blame the lenders, some perhaps the supervisors and regulators. Tilford prefers simply to blame the euro. But he offers not a shred of evidence either in support of a hypothesis that the euro necessarily increases debt, or of a hypothesis that debt has caused a greater problem for indebted countries who have joined the euro system than they would have faced with the same level of debt outside it (external devaluation would surely lead to inflation, a banking crisis, and the bankruptcy of businesses or households with euro - or dollar - debt. and would of course remove all pressure for structural reform and productivity growth). There is an obvious link between debt and the business cycle - and between excessive debt and serious recession. But there is no necessary or causal connection between the euro and the grave recession we have all been passing through, and to suggest one without evidence is surely to fall into the classic fallacy of confusing timing with causality - post hoc propter hoc.

Simon Tilford said...

The problem is that the level of “debt” is more determined by real interest rates than by “short-term bankers' bonuses, conflict of interest, other dishonesty or sheer incompetence”. All countries had this problem. The reason why the eurozone with its one-size-fits-all interest rate amplifies the credit cycle is well known: see CER’s latest piece on this here: This point has been central to the debate about the eurozone from the beginning: unless economies converge to the extent that a single interest rate does not lead to credit imbalances the eurozone will continue to be an unstable place. There is now divergence because a number of poor countries are caught in debt traps.

Quentin Davies said...

”Simon Tilford has failed to understand my essential point. Of course debt is a (negative) function of real interest rates. And in monetary union the base or “risk free” interest rate is common across the system. But individual borrowing rates certainly should not be. They are made up of the “risk free” rate plus a spread or margin determined by lenders or bond holders to reflect the risk. My point was that pre-Lehmann these spreads were quite irresponsibly compressed – and quite inadequate to the risks of, for example, Greece, or Spanish real estate developers. That was the fault of “lenders, fund managers and (bond) underwriters” – not the euro.

Simon Tilford said...

Would spreads have compressed to that extent if the euro had not existed? Would these countries have had more mechanisms for adjustment outside the euro? The answer to the first question is no and to the second yes.