The European fallacy of Ireland and the Baltics
Another excellent paper by Simon Tilford from the Centre for European Reform.
Eurozone policy-makers – from President Sarkozy and Wolfgang Schäuble to the former President of the ECB, Jean-Claude Trichet – advocate that Italy and Spain should emulate the Baltic states and Ireland. These four countries, they argue, demonstrate that fiscal austerity, structural reforms and wage cuts can restore economies to growth and debt sustainability.
Latvia, Estonia, Lithuania and Ireland prove that so-called "expansionary fiscal consolidation" works and that economies can regain external trade competitiveness (and close their trade deficits) without the help of currency devaluation. Such claims are highly misleading. Were Italy and Spain to take their advice, the implications for the European economy and the future of the euro would be devastating.
As Mr Tilford makes clear, these arguments are demented. To the extent that such policies are implemented by the whole of Club Med in unison – without offsetting increase in demand in North Europe, or monetary stimulus – they will prove self-defeating and lead to economic depression. In my view they may also lead to incipient Fascism and a host of evils, but we are not there yet.
Unfortunately, this is the current policy direction under the EU "fiscal compact" – imposed on Europe by Teutonic Diktat – and is why the IMF is now in such high dudgeon. The IMF's new forecast is contraction of 2.2 per cent for Italy and 1.7 per cent for Spain this year.
The Fund has shaved 5pc off Spanish GDP over two years from its earlier forecast. This will push the debt/GDP ratio up by 11 percentage points – such is the sensitivity of the debt trajectory to growth levels. Italy's debt will be 6.5pc higher, reaching 127pc by next year despite big fiscal cuts. This is above the level deemed sustainable for Greece, by the way.
"This could be a wake-up call to those who think aggressive fiscal tightening alone will stabilise public sector finances. By following the German orthodoxy, much of the euro area is now caught up in a downward debt spiral," said Marchel Alexandrovich from Jefferies Fixed Income.
Ireland and the Baltics have all been subjected to brutal contractions. As small open economies with flexible labour markets, they have survived this shock.
Survival does not in itself vindicate the policy. We usually require a higher standard.
In the case of the Baltics, the proper question to ask was whether it was worth causing a violent rise in unemployment for the sake of a euro-peg and the sanctity of the EMU project. Output has not regained its former level. The economies have suffered lasting damage, and a great number of lives have been blighted.
If you were a Left-winger, you might ask whether it is honourable that large numbers of blue collar workers should be tossed onto the street of Riga in order to prevent a devaluation that would have exposed middle class homeowners to big losses on euro, franc, and yen denominated mortgages. The poor were sacrificed for the interests of the rich.
Be that as it may, the Baltics are sui generis. Estonia had no public debt at the outset of the crisis. It had a surplus. This eliminated the risk of Fisherite debt-deflation.
It is an entirely matter in Club Med. Savage fiscal contraction has already been ruinous in Greece, will be ruinous in Portugal, and will push Italy and Spain over the brink if seriously attempted there too.
I might add that the Baltics have only recently regained sovereignty from the Soviet Union, and have a revanchist Russia breathing down their neck. It is a national imperative for these countries to lock into the EU system as deeply as they can, whatever the pain. Spain and Italy are different political animals.
As for Ireland, it has certainly been heroic, carrying out a genuine "internal devaluation", at the cost of 22pc contraction in GNP (not to be confused with GDP). It has clawed back a current account surplus with exports of pharma and IT. But Ireland is a special case. It is an aircraft carrier for US and global multinationals, and has the most flexible economy in Euroland.
Ireland has indeed done so well that it was able to start dipping its toe back into the debt marktets this week. But the country is not yet out of the woods. If the IMF is right in its dire forecasts for Europe this year and next, Ireland is about to suffer a fresh shock.
Here are some of Mr Tilford's thoughts:
What have the three Baltic economies and Ireland done to draw such acclaim? All four have experienced economic depressions. From peak to trough, the loss of output ranged from 13 per cent in Ireland to 20 per cent in Estonia, 24 per cent in Latvia and 17 per cent in Lithuania. Since the trough of the recession, the Estonian and Latvian economies have recovered about half of the lost output and the Lithuanian about one third. For its part, the Irish economy has barely recovered at all and now faces the prospect of renewed recession.
Domestic demand in each of these four economies has fallen even further than GDP. In 2011 domestic demand in Lithuania was 20 per cent lower than in 2007. In Estonia the shortfall was 23 per cent, and in Latvia a scarcely believable 28 per cent. Over the same period, Irish domestic demand slumped by a quarter (and is still falling). In each case, the decline in GDP has been much shallower than the fall in domestic demand because of large shift in the balance of trade.
The improvement in external balances does not reflect export miracles, but a steep fall in imports in the face of the collapse in domestic demand. Estonia had a current account deficit equivalent to 17 per cent of GDP in 2007, but by 2011 this has become an estimated surplus of 1 per cent of GDP. Latvia and Lithuania experienced shifts in their external balances of a similar magnitude. Ireland went from a deficit of 5.6 per cent of GDP in 2008 to a small surplus in 2011.
There is little argument that all four countries needed to narrow their trade deficits. But countries that have experienced such enormous declines in domestic demand, and whose economic growth figures have been flattered by a collapse of imports (and hence improvement in trade balances) hardly provide a blueprint for others, let alone big countries.
Spain and Italy could close their trade deficits if they engineered economic slumps of the order experienced by the Baltic countries and Ireland. But a collapse in demand in the EU's two big Southern European economies comparable to that experienced in the Baltic countries and Ireland would impose a huge demand shock on the
European economy. Taken together, Italy and Spain account for around 30 per cent of the eurozone economy, so a 25 per cent fall in domestic demand in these two economies would translate into an 8 per cent fall in demand across the eurozone. The resulting slump across Europe would have a far-reaching impact on public finances, the region's banking sector and hence on investor confidence in both government finances and the banks. The impact on sovereign solvency in Spain and Italy and on the two countries' banking sectors would be devastating.
There are other factors that undermine the relevance of the Baltic and Irish experiences. In the face of mass unemployment, emigration, especially from Ireland and Lithuania, has ballooned. In the year to April 2011 alone, Irish emigration topped 76,000. The figures are similar for Lithuania, with 83,000 leaving in 2010.
Comparable totals for Italy and Spain would be 1 million and 750,000 respectively. Moreover, the Irish have overwhelmingly moved to countries outside the eurozone (Australia, Canada, the UK and US). By contrast, a significant proportion of the very much larger number of Spanish and Italians would presumably be seeking work elsewhere in the currency union. The robust German labour market could absorb some migrants, but nothing like the numbers involved.
Despite massive movements in external balances that could not be repeated elsewhere and emigration that could not easily be emulated by others, Ireland, Latvia and Lithuania has experienced dramatic deteriorations in their public finances. Including the cost of bailing out Ireland's banks, public debt has risen from just 25 per cent of GDP in 2007 to over 100 per cent in 2011. In Latvia the debt to GDP ratio increased from 9 per cent to 45 per cent over this period and in Lithuania from 16 per cent to 38 per cent. The exception is Estonia, which has managed to run largely balanced budgets over the last four years.
Italy and Spain have few lessons to learn from the experience of the Baltic countries or Ireland. Those advocating that Italians and Spanish emulate these economies should admit that they are arguing in favour of an unprecedented slump in domestic demand. They should then demonstrate how this would be consistent with the solvency of both governments and banks in Italy and Spain. Finally, they should explain how the European economy as a whole could cope with an economic shock of this order.
The advocates of such a strategy are promoting dangerous nonsense. They should be confronted head on. Fortunately, the IMF has taken up the challenge. Let us all hope that Christine Lagarde finally makes it clear to Angela Merkel that the world is seriously displeased.