Perspectives from Around the World

Eurozone's Malaise: Is there a way out?

Salvatore ZECCHINI
Professor of International Economic Policy at University of Rome "Tor Vergata" and Chair of the OECD WPSMEE and its Steering Group

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More than a decade since the launching of monetary unification in Europe, the euro area is currently facing the most challenging test of euro viability, not to say its survival, having to cope with the consolidation of both a faltering economic recovery from the severest recession since the Great Depression and the distressed public finances of major member economies and small economies as well. This task is made almost intractable by financial markets' overreactions to stubborn budget deficits and hefty sovereign debts.

But to view the current crisis as the sole product of financial markets' tensions and changed sentiment is like missing the whole picture, because the ultimate cause of the current confidence crisis lies in the persistent prospects of economic stagnation and its deeply entrenched roots. With dim growth expectations after a decade of relatively little expansion, the accumulated public debt could become too burdensome, social forbearance of austerity too thin, the risk of default too high, and the temptation for using inflation as an easy way out too hard to resist.

Still, the advent of the euro was hailed in Europe as marking a new era of economic revival, with trade, investment, entrepreneurship and innovation expected to provide a vigorous boost to growth, while eradicating inflation risks, due to an independent monetary policy geared to achieving medium-term price stability. The reality is, alas, at some distance from such a scenario. In the past decade, real GDP rose by a paltry 1.1% per year, less than half the growth recorded over the previous two decades; real per-capita GDP at the end of the decade was just 4.8% higher than at the beginning, while consumer inflation hit perfectly the 2% annual target adopted by the ECB.

Although economic performance varied significantly across the area, with continental member countries performing much better than their southern partners, overall, the euro economy showed little resilience to the several shocks that it experienced. These include in turn the bursting of the stock market bubble, quadrupling of the oil price in dollar terms, the fall of the US currency in the exchange markets, the global financial crisis, the severe recession and, lately, the sovereign debt crisis.

No solace in the fact that Japan, another advanced economy exposed to the same shocks, didn't perform better. Over the same period, Japan's growth was lower (0.7% per year, +2.7% on a per-head basis), deflation was almost a constant, and fiscal deficits rose to a level almost double (5.8% of GDP vs. 3%). While sharing some of the same problems, the Japanese economy had some of its own, such as problems in the banking sector and stagnation in population growth. Even so, there were some strong points, such as rising external competitiveness.

Low growth and inadequate resilience in the euro area can be traced back to three main factors: lagging productivity growth alongside worsening competitiveness, population ageing, and rigidities in the labour and product markets. Labour productivity rose by just 0.57% on a yearly average basis, while wage compensation per head in the business sector increased by 2.4% per year. A major exception to these trends was Germany, which succeeded in restraining wage rises between 2004 and 2007 and raised productivity at the same time. Austria and the Netherlands also managed to achieve significant productivity gains in the same years. The outcome was, however, that over the past decade, the euro area's competitiveness--measured in terms of movements in exchange rates and unit labour costs--worsened by 23%, while that of Germany improved (about 4% in 2010/2000). As a comparison, Japanese competitiveness surged by an astonishing 31%.

These trends are compounding the pains of growing of the euro economy with an ageing population, as ageing leads to a shrinking labour force and puts higher demands on the economy to fund rising welfare costs. In the presence of overall stagnation of population growth (with less advanced economies being the exception), the employment rate of those over 60 years of age didn't rise as needed, except in the latter years of the decade in conjunction with the harsher economic conditions brought about by the recession.

More flexible use of a stagnant labour force would have eased the problem, but, in fact, the euro area lacked major advances in structural reforms, particularly on two fronts: 1) in making labour markets more adaptable to changing competitive positions in terms of wage setting and worker mobility, both sectoral and territorial; and 2) in liberalizing product markets to spur entrepreneurship, innovation, and investment in R&D. Some progress was made, especially in view of the so-called Lisbon Strategy, but at an inadequate speed and at an uneven pace across countries and sectors, with final results for the area falling short of the pre-determined quantitative objectives. For instance, the service sector, which represents the largest component in national product formation, was left largely untouched by liberalization and external competition. Furthermore, the labour participation rate and R&D expenditure were not brought up to their targets.

Still, the success of any monetary union, according to the optimal currency area approach, is predicated on the mobility of production factors and wage flexibility. The euro area's policy governance, however, did not deliver enough of these important goods so as to reach the real side of the various member economies the degree of convergence that is required to warrant a country's continuing adhesion to a common currency and a common monetary policy.

Flexibility is all the more necessary at this time, when the area has to face the strong competition of emerging economies from Asia, as well as from Eastern Europe and Latin America. The radical changes that have been occurring in the international division of labour and Euro countries' demographic trends and structural rigidities in responding to the competitive challenge of emerging economies concur to explain a good portion of the growth difficulties currently experienced in the euro area. Even though this has not come unexpectedly, not all the European democracies have been able to respond properly and timely to these challenges. The southern belt countries of the euro area, those that built social consensus on cuts in deficit spending, very high labour protection, and generous welfare, are now finding themselves in the worst position.

All euro countries are anyway confronted with the same basic constraints: lack of room for a fiscal stimulus because of the urgency to lower debt/GDP ratios, which were inflated by the recession; unavailability of inflation or real depreciation of the exchange rate as a policy tool, because of the euro policy geared to financial stability; absence of an external booster to aggregate demand because all major OECD economies are reining in excessive fiscal deficits at the same time; stiff social resistance to backtracking on the extensive social protection system provided by pensions, unemployment benefits, health care, labour regulations; financial markets with heightened risk aversion; flimsy social acceptance of the necessary austerity.

Faced with so many demanding constraints, some would argue that in the eurozone there is no way out of a long period of sluggish growth, social tensions, and veiled protection of domestic producers. Still, it is hard to believe that the area is doomed to stagnation, or worse, to a breakdown. In such circumstances, it is the quality of policymaking that makes the difference and can run counter to widespread negative expectations. This quality leap by the euro countries' leadership is possible and can deliver a way out, if only they would engage themselves in such an effort.

A way out of the euro malaise exists and has at its core a determination by policymakers to overcome the usual reliance on aggregate demand management in order to focus on supply-side policies and effective international economic cooperation. The full spectrum of supply-side measures has to be used for reviving economic growth, knowing that there will be little room in public budgets to ease the inevitable social costs during the adjustment phase. In other words, a revival of modern-age "industrial policy" --an industrial policy that doesn't aim at backing up failing sectors or firms, but at spurring structural renewal-- could greatly improve growth prospects by creating a domestically-induced engine for growth.

A strategy should look at the micro structure of domestic markets, production base, and factors of production with a view to making improvements. When taken one by one, the effect would be limited, but together could add up to a sizeable progress in productivity and competitiveness. The list of appropriate measures is too long to be covered in a short presentation. But a few hints would suffice to give a sense of the main direction towards which it is essential to push ahead.

  • Create a better environment for entrepreneurship, business development and start-ups, by cutting deeply into bureaucratic hindrances and simplifying compliance with rules, regulations, and tax requirements.
  • Channel more private resources toward infrastructural projects that are functional to improving firms' competitiveness and can be considered self repaying. Ease red tape posing hurdles to their realization. As borrowing costs are at all-times lows, there are more opportunities than in the past to reap good returns on investment. At the same time, shift more public resources toward infrastructural projects by cutting down on consumption expenditure.
  • Make the diffusion of new technologies such as the "green" ones, a driver of sustained investment, by leveraging regulations, the green tax-cum-subsidy, and market mechanisms at no extra-cost for public budgets.
  • Promote innovation and the linkup of R&D centres with the business sector to make the findings of research available to a larger number of SMEs.
  • Deregulate the main components of service industries, such as transport, local utilities, network industries, and wholesale and retail distribution, with a view to fostering higher competition and innovation.
  • Push all sectors, including public bodies, to adopt ICT in their operations. Promote the winding down of obsolete industries, making it easier to write off assets and to channel capital to expanding industries.
  • Support SMEs' entry into the world market in order to spur their ability to compete, their propensity to invest, and their opportunities to grow.
  • Address some of the rigidities in the labour market and employment, to foster workers' mobility across sectors and over the territory, and make it more costly to resist mobility. Provide benefits to firms that engage themselves in retraining workers with obsolete skills.
  • Make welfare systems compatible with the objective of an active society rather than that of a community of elderly people fit to work but with neither opportunities, nor inducements to work. For instance, involvement of people over the age of 65 in the working community should be encouraged by allowing more flexibility in working contracts and making such activity more rewarding.
  • Inject and enforce more competition in the finance and insurance sectors to lower services costs.
  • Leverage public backing (e.g., guarantees) in order to widen SMEs' access to financing and lower its cost.
To condense the listed measures into a simple philosophy, we could say: "Less pump priming of demand and more competition, innovation and technological renovation."

Not all the advocated measures belong to the domestic realm, since international cooperation can help in boosting synergies, mitigating the adjustment costs, and not neutralizing the benefits of structural reforms to euro countries. On the international scale, three major threats must be defused to support the domestic drive to reform: protectionism tendencies, currency misalignments, and excessive use of market power in critical commodity and energy markets. Should these threats continue or become bigger, euro countries' willingness to push for domestic reforms would falter and a more worrying scenario might emerge. After all, in Western-type democracies, no reform can be carried out without adequate social and political support, and the latter is already thin at difficult times. But there can be no doubt that through blood, tears and international support, the euro area will show its endurance and ability to overcome its current malaise sooner rather than later.

September 2011

September 1, 2011

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