Said otherwise, most European countries (including France) face a desperate need for external devaluation, which is impossible under a monetary union, leaving only internal devaluation as an option. This is where the much maligned concept of austerity comes in: from a macroeconomic perspective, austerity is not so much an exercise at moderating the pace of debt increase (as neither Spain nor Italy have reduced their rate of debt issuance), but of gradually becoming more price competitive with Germany: a key outcome that will be needed for the Eurozone to have any chance of survival, i.e., lowering sticky unemployment rates from levels that virtually assure social "disturbances" in the months and years ahead.
And herein lies the rub: because while protests against “austerity” (which as we observed recently has still not been truly implemented in Europe, and certainly not in Portugal or Spain) are a daily event in most PIIGS nations, “you ain’t seen nothing yet.“ The reason: to achieve the unavoidable macroeconomic rebalancing, and to collapse the spread between soaring labor costs in the periphery and those of Germany (see chart below), the bulk of European countries will need to see wages collapse by anywhere between 30% and 50% to compensate for the lack of state-level currency devaluation optionality. And yes, this includes France.
We ask the following question: For the Euro area countries of interest, how big a real exchange rate depreciation (which (to recall) in monetary union means (to a first approximation) a relative wage cut) is required in order to establish a sustainable external position .…
The results of our exercise are shown below. They demonstrate that relying solely on internal devaluations to correct existing imbalances implies a need for very large wage and cost adjustments. For the small and vulnerable peripheral countries (Greece and Portugal), we would need to see wages fall by at least 50% relative to Germany (from their level at the start of 2011) if this mechanism alone were to re-establish external sustainability. And even for larger and richer countries such as Spain and France, relative wage reductions (on a comparable basis) of 30%+ are needed.
Which begs the question: how will the long-suffering workers of Greece, Spain, and Italy (and also France), who are confident they have gone to the 9th circle of hell in the past 4 years, react when they realize that none of the needed internal devaluation has actually taken place yet?
In other words, what happens when Spanish wages tumble by another 30%, as they must if the EUR, and the Eurozone, is to survive? Alternatively, if there are no labor cost cuts, how many more years and months of 1%/month unemployment increases will the unemployed in the periphery suffer before it realizes that chronic 25%+ unemployment is here to stay, as is the European Depression. What is most sad is that the economic reality is that regardless of the “all clear” that central-bank-manipulated market indicators tell us, the European imbalances continue deteriorating at a rapid pace.
And the paradox is that as long as market indicators aren’t flashing red, no politician has the urge to enact the critical laws needed to fix the underlying problem, as that same fix will lead to an immediate end of said politician’s career.
Needless to say, not even Goldman thinks that kindly asking for Greek and Spanish workers to take another 30-50% pay cut is feasible and would lead to anything short of revolution (and the alternative: asking Germany to adopt a wage increase and watch German inflation surge is just as ludicrous):
So does this mean that despite all best efforts to the contrary, when one looks beyond the daily hollow rhetoric emanating from Brussels and focuses on the simple economics of it all, that the Eurozone is doomed? While our pessimistic opinion on the viability of the failed European project is well-known, not even Goldman can bring much words of encouragement:We view relative wage cuts of this magnitude as unfeasible: it is difficult to imagine France accepting a one-third fall in living standards relative to Germany. Of course, one could rely on Germany to raise wages, so as to redress the competitiveness gap from the other side. But ultimately such an approach would imply Germany accepting much higher rates of inflation, say above 4% pa for a decade or more, assuming the ECB met its target of keeping area-wide inflation close to 2%. We doubt the German public would countenance such an eventuality….
It is worth pointing out that the ad hoc and very much informal (after all Merkel’s reelection chances are much lower if the German people understand what is really happening in Europe) transfer union has worked so far primarily because it funded the relatively modest economy of Greece. Yet even ordinary Germans understand that the Bundesbank’s TARGET2 claims are nothing more than Germany’s implicit fiscal transfer mechanism to the rest of Europe (one which happens to benefit German exporters: i.e., a public to private transfer scheme), one which is soaring by tens of billions each month.To answer that question, we need to explore the implications of relaxing some of the assumptions that underlie the exercise described above. First, we could implement the necessary relative wage adjustment through resort to nominal exchange rate changes. But allowing exchange rates to vary implies exit from the Euro area and reintroduction of national currencies. Relying on this mechanism implies recognising the impracticality of the euro, rather than describing how it can be saved.
Second, uncompetitive economies could suppress domestic demand to contain imports and run with mass unemployment on an ongoing basis. In our view, this is not politically feasible. British experience in the late 1920s (following Winston Churchill’s decision to put Britain back on the Gold Standard at its pre-first World War parity) demonstrates as much. High unemployment, recessionary conditions and lost export markets were the precursors to abandoning gold rather than mechanisms for sustaining British adherence to it. One would expect as much for the Euro area periphery: if mass unemployment become endemic and permanent, it would eventually precipitate euro exit.
Third, uncompetitive peripheral countries could be subsidised on an ongoing basis by the more competitive surplus countries, i.e., a system of fiscal transfers from north to south could close the current account deficit and eliminate the existing imbalances. Such mechanisms are quite normal in continental monetary unions: witness the transfers from wealthy New York to poorer West Virginia via the federal government in the United States.
But the institutional mechanisms and political support for such area-wide redistribution are (as yet, still) lacking in the Euro area.
To be sure all such indefinite ad hoc attempts to delay the day of “labor-cost equivalency”-reckoning using piecemeal and incomplete fiscal transfers from Germany to everyone else, will one day fail, when surging nationalist parties across Europe just say “nein” to ceding sovereignty to Germany which will eventually demand all Europe bow down to it in exchange for a full-blown fiscal union and Eurobond initiative in which Germany officially bears the cost of “temporary-to-permanent” Current Account imbalances, by shifting from TARGET2 to a wholesale German-funded fiscal union. This “unthinkable scenario” is quite thinkable by most, especially Europe, but in this case certainly Goldman:
The only good news to date, if one may call it so, is that Spain has already taken some modest steps to address its internal devaluation. However that former AAA-stalwart, and now bastion of resurgent socialism, France has not. And it is here that those who took offense to that recent edition of The Economist with the ticking time baguette cover should be paying attention.A number of the options listed above are feasible for the smaller peripheral countries. Since the magnitude of structural change required to make them sustainable is so large (and the institutional capacity to implement those changes open to question), it is likely that we will see a prolonged period of both mass unemployment and subsidisation if they are to remain within the Euro area. This has been the experience thus far. Indeed, recent discussions over the terms of financial support for Greece in Brussels can be seen as a codification of how the subsidies will be provided in that case.
At the same time, we should not ignore the possibility of exit: were the rest of the Euro area to develop sufficient robustness to manage the transition, one could easily imagine a Euro without Greece or Cyprus.
But for the larger countries, options are much more limited. It is unthinkable to have a Euro area without France; at that point, it would become little more than a greater Deutsch mark zone. The politics of perpetual mass unemployment are equally infeasible as in the small peripheral countries. And France and Spain are simply too large to subsidise on an ongoing basis. So there is no alternative but to implement a restructuring of the economies to reduce the needed real depreciation to a plausible level. But the nature of the restructuring needs to be tailor-made for the country concerned.
And then there is that other wildcard: the UK. As CLSA’s Chris Wood writes in his latest edition of Fear and Greed:Spain’s economy is weak and vulnerable at present. But while of little comfort to those unemployed, there is a silver lining to that weakness: it is associated with a necessary restructuring that offers hope of a more balanced and competitive Spanish economy in the future.
Unfortunately, there are reasons for greater caution with regard to developments in France. Like Spain, France also needs to shift resources into the tradable sector in order to reduce its chronic and deteriorating current account deficit. But France’s problem is not a bias towards the construction sector as in Spain, but rather a bloated public sector. Public expenditure in France is 56% of GDP, compared with 47% in Germany: the inherently domestic-oriented nature of government spending implies that France produces too few tradable goods relative to Germany.
In Spain, a largely spontaneous bursting of the housing bubble initiated the necessary restructuring of the economy. But in France a conscious political decision to shrink the state is needed to achieve the restructuring. And the political obstacles to that decision are high. While the French authorities increasingly recognise the need to improve French competitiveness, developing an understanding that this implies a deep restructuring of the economy remains elusive, at least at the political level, as recent discussion of industrial policy attests.
All of the above is correct: the true European fulcrum nations have now shifted from the PIIGS to France and the UK, but it will take some time for this to become evident. What is unclear is the question of timing. And with Europe hell bent on actually addressing the real underlying causes for its persistent recessionary state instead of merely attacking the symptoms (soaring yield spreads, plunging equity markets, diving EUR FX rate), one can be sure nothing will change as long as the ECB gives the impression that European imbalances are under control, courtesy of a bond purchase backstop, which sooner or later will be activated at which point this too threat will become reality, and like QEternity, will lose all potency.Europe, the path ahead for the Eurozone was made crystal clear with a plan unveiled by European Commission President Jose Manuel Barroso on Wednesday, outlining the need for an overhaul of Eurozone institutions to pave the way for the collective issuance of debt. This fits GREED & fear’s base case; namely that the Eurozone is moving towards “debt mutualisation”, a process which will ultimately lead to fiscal union. This week’s “deal” on Greece, with its extension of maturities and lowering of interest rates, is a further indication of the political determination to keep the Eurozone going in its present form and the unwillingness to contemplate the stresses of a Greek exit.
The above is also why the real political tension triggered by the direction in which the Eurozone has now embarked will turn out to be in Britain, not Spain or Greece. This is because there is real antagonism towards the Eurozone in Britain whereas in Greece and Spain the majority of people continue not to blame the euro for their problems. This is why it is possible that the Eurozone can make a deflationary adjustment, as indicated by the periphery countries’ improving current accounts. It is also why Britain’s fresh-faced Prime Minister, David Cameron,has a political problem.
It is only then that Europe will have some hope of finally addressing that which is the true basis for its unsustainability: the internal imbalances which in the absence of currency adjustments can only be addressed through collapsing labor costs, and wages.
Yet telling a continent, which in its desperation is hopeful and confident that the worst is behind it (as its lying politicians take every opportunity to note) that the most acute of standard of living collapses is yet to come, is borderline cruel and unusual. So we will just keep our mouths shut and let Europe’s politicians bring this depressing message to their people. We are confident the reaction will be more than dignified.
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