Blog Post

Is struggling Europe on the right track?

The latest European Commission outlook forecasts 2014 unemployment rates above 25 per cent in Greece and Spain, in the vicinity of 15 per cent in Ireland and Portugal, but close to 5 per cent in Austria, Germany and the Netherlands. In the same year it expects GDP per capita to be almost 7 per cent above the pre-crisis level in Germany, but about 7 percent below in Ireland, Portugal and Spain, and a terrifying 24 per cent below in Greece. So the deep economic and social divide that as emerged within the euro area is expected to linger.

By: Date: February 27, 2013

The latest European Commission outlook forecasts 2014 unemployment rates above 25 per cent in Greece and Spain, in the vicinity of 15 per cent in Ireland and Portugal, but close to 5 per cent in Austria, Germany and the Netherlands. In the same year it expects GDP per capita to be almost 7 per cent above the pre-crisis level in Germany, but about 7 percent below in Ireland, Portugal and Spain, and a terrifying 24 per cent below in Greece. So the deep economic and social divide that as emerged within the euro area is expected to linger.

Such a gulf within a monetary union cannot be sustained for very long. The same monetary policy cannot possibly fit the needs of a country in depression and another one that is at, or close to full employment. Therefore the single most important issue for the future of the euro area is whether the gap within it between a still-prosperous half and a struggling half is in the process of being corrected.    

The optimistic reading is that although there is no improvement in sight on the labour market front, things have in fact started to go better and that an adjustment process is under way. The proof, it is often argued, is that external deficits have contracted substantially (Figure 1)

Figure 1: Current-account balances in percentage of GDP

Source: AMECO, Winter European Commission forecast

It is true that the external account matters, as it reflects the balance between domestic saving and investment. Up until 2007, imbalances within the euro area had largely resulted from too low savings and/or excessive real estate investment, resulting in debt accumulation. The contraction of external deficits is a sign that a correction is under way. Second, the rebalancing is genuine: in Spain, Portugal, and Greece the deficit has been reduced by more than 7 percentage points of GDP since 2007, and in Ireland it has been turned into a surplus.

The problem, however, is that the collapse in domestic demand accounts for a large part of this improvement. Since 2007 it has dropped by about one-fourth in Greece and Ireland, and by one-eighth in Spain and Portugal. Investment in equipment – which is key to ensuring the build-up of productive capital in the tradable-gods sector – has generally suffered even more. For sure demand contraction was inevitable as these countries were living far beyond their means. No economy can permanently sustain demand growth above the growth of GDP. But what we have seen since 2007 is an overshooting of demand and domestic investment contraction. This cannot be regarded as a success.              

Table 1: Change in the volume of domestic demand

2002-2007

2007-2012

Euro area

10.8%

-3.0%

Germany

4.1%

4.3%

Ireland

32.2%

-22.7%

Greece

25.6%

-27.6%

Spain

25.2%

-12.7%

Portugal

4.7%

-12.4%

Source: AMECO, Winter European Commission forecast

News are better on the export side. In spite of a grim environment, exports-to GDP ratios have noticeably increased in all four economies. Ireland was known to be a very reactive, outward-oriented economy. But it’s not only Ireland. Confronted to a collapse of the domestic economy and a stagnant European environment, firms in Greece, Spain Portugal have turned to overseas markets and significantly increased their countries’ shares of euro-area exports to the rest of the world (Figure 2). Spain’s performance on foreign markets is especially impressive. On the eve of the euro its exports outside the EU were one-fourth of those of the French ones. They now represent almost one-half of them.

Figure 2: Shares of euro-area exports to non-EU countries 

Source: AMECO, Winter European Commission forecast

The question, to which it is difficult to give a firm answer, is which part of these exports is for-survival and which is for-profit and whether, therefore, their performance can be considered lasting. This brings us to the issue of price and cost adjustment. During the euro’s first decade, the countries that are now struggling recorded persistently higher wage and price inflation than those of the North. To recover and return to both internal and external balance they must not only close the cost gap, but actually reverse it as they have accumulated foreign debt in the meantime, and will have to record trade surpluses to repay it.

News on this front are mixed. Since 2007 labour costs have roughly stagnated in Greece, Spain and Portugal (though the mix between wage cuts and productivity gain varies from country to country) and they have contracted by 8% in Ireland, whereas they have increased by more than 10 per cent in Germany. So a rebalancing is under way. Contrary to stereotypes, for example, real wages in Greece have declined by 6 per cent per year over the last three years. The problem, however, is that prices have generally proved much more rigid. Only Ireland stands out as a country where they have declined. In the rest of struggling Europe their adjustment is barely noticeable. Firms, especially in the sectors sheltered from international competition, have kept market power and they have also increased prices in response to the rising cost of capital (Table 2).

Table 2: Evolution of GDP price deflator, 2007-2012

Germany

5.1%

Ireland

-7.9%

Greece

8.7%

Spain

3.8%

Portugal

3.6%

Source: AMECO, Winter European Commission forecast

The result is that the process of internal devaluation, as economists call it, is seriously hampered. Employees have suffered wage cuts but prices have not declined accordingly, so their loss of purchasing power is bigger than it should be, and economies have not recovered lost competitiveness, so employment, especially in the traded-goods sector, is lower than it should be.

Austerity and reforms were supposed to deliver rebalancing within the euro area. They have, as far as external balances are concerned. But in spite of visible progress on the export front and noticeable labour cost reductions, this rebalancing is mostly the effect of the same collapse in domestic demand that is creating mass unemployment. Ultimately perhaps, it will pay off. But societies may lose patience in the meantime. This should be enough to prompt a reassessment. The issue is not whether fiscal consolidation and external rebalancing are necessary – they are. It is how to make them politically and socially sustainable.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Topics

Comments

Read about event More on this topic

Past Event

Past Event

Fighting corruption: from headlines to real impact

Despite recent efforts to tackle corruption there is not much evidence that these strategies are producing results. Why is this the case and what can we do to improve the situation?

Speakers: Carl Dolan, Mihaly Fazekas, Alina Mungiu-Pippidi and Alessio Terzi Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: April 28, 2016
Read about event More on this topic

Past Event

Past Event

Active labour market policies, what works?

How are Europe's labour markets performing, and what policies can best help them function?

Speakers: Alfonso Arpaia, Clyde Caruana, Grégory Claeys, Dan Finn, Regina Konle-Seidl, Alfred Mifsud, Godwin Mifsud, Edward Scicluna and Paul Swaim Topic: European Macroeconomics & Governance Location: Mediterranean Conference Centre Triq l-Isptar, Valletta, Malta Date: April 27, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

Understanding HM Treasury’s Brexit analysis

What’s at stake: The UK will hold a referendum on its membership of the EU on June 23rd 2016. Her Majesty’s Treasury released an assessment of the impact of Brexit finding that the economy would be between 3 and 7% smaller in 2030 if the UK left the EU than it would be if it stayed in.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: April 25, 2016
Read article More on this topic More by this author

Blog Post

jaume

Are regional governments causing deficit overshooting in Spain?

Spain once again missed its deficit target in 2015 and it seems unlikely that 2016 will be any better. The central government has pointed to regional deficits as being the cause of the fiscal slippage. However, regional governments claim that their deficit is due to under-financing and overly strict deficit targets.

By: Jaume Martí Romero Topic: European Macroeconomics & Governance Date: April 19, 2016
Read about event More on this topic

Past Event

Past Event

CANCELLED: The Search for Europe

This event has been cancelled because of an unforeseen change in the calendar of the main speaker.

Speakers: Francisco González, Sylvie Goulard, Veronica Nilsson, John Peet, Javier Solana and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: April 19, 2016
Read about event More on this topic

Upcoming Event

25 
May
2016
12:30

Lessons for the euro from early US monetary and financial history

The United States has a monetary union that many look to when considering the future of the EU. But how easy was it really to create such a union and what can Europe learn from the US process?

Speakers: Jeffry Frieden and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic

Blog Post

IMG_20151009_103117 (3)
Karen E. Wilson
Guntram B. Wolff

Youth unemployment in the Mediterranean region and its long-term implications

Youth unemployment in the Mediterranean region has consequences for the whole of Europe. Tackling youth unemployment in the region must continue to be a high policy priority.

By: Nuria Boot, Karen E. Wilson and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 13, 2016
Read article More on this topic

Opinion

Grégory Claeys
Zsolt Darvas

How to reform EU fiscal rules

The current inefficient European fiscal framework should be replaced with a system based on rules that are more conducive to the two objectives of public debt sustainability and fiscal stabilisation.

By: Grégory Claeys and Zsolt Darvas Topic: European Macroeconomics & Governance Date: April 12, 2016
Read article More on this topic More by this author

Opinion

Guntram B. Wolff

Making the EU-Turkey refugee deal work

The EU deal with Turkey reached on 18 March is problematic, but without a deal the EU’s external borders would have collapsed completely. Now the EU needs to support Greece and increase the number of refugees taken directly from Turkey.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 11, 2016
Read article More on this topic

Opinion

fratzscher-03
Reint_Gropp_m
p2-Kotz
jan-pieter-krahnen
odendahl-june14-1409577172
Beatrice Weder di Mauro
Guntram B. Wolff

Mere criticism of the ECB is no solution

What would happen if the ECB failed to respond to the excessively low inflation and the weak economy? And what economic policy would be suitable under the current circumstances, if not monetary policy?

By: Marcel Fratzscher, Reint Gropp, Hans-Helmut Kotz, Jan Krahnen, Christian Odendahl, Beatrice Weder di Mauro and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 10, 2016
Read article More on this topic More by this author

Blog Post

Zsolt Darvas

The structural budget balance limbo

A key indicator in the EU’s fiscal framework is the structural budget balance, but estimates of the indicator by the European Commission, IMF and OECD are revised a lot from one year to the next, sparking concerns among some EU finance ministers.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: April 7, 2016
Read article More on this topic

Opinion

Agnès Bénassy-Quéré
Guntram B. Wolff

ECB decisions put lack of fiscal union in the spotlight

Fiscal policy in the euro area is hardly supporting the recovery and the ECB. The EU needs a a proper fiscal union in order to stabilise the economy and inflation. We see four main avenues for achieving a viable fiscal framework.

By: Agnès Bénassy-Quéré and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: March 30, 2016
Load more posts