There can be no eurozone stability without economic growth

There can be no eurozone stability without economic growth

Bulletin article
01 April 2010

The German government believes that tougher fiscal rules are the solution to current strains in the eurozone. No doubt such rules are necessary. But they are not enough. In order for the eurozone to become stable, three other things need to happen: South European member-states must boost productivity growth; northern ones – notably Germany – have to strengthen domestic demand and reduce their current-account surpluses; and there should be greater institutional integration. While the South European countries may eventually be forced by the bond markets to reform their economies, there seems little chance of the other two criteria being met.

Greece’s economic management has unquestionably been profligate. The country squandered the decline in borrowing costs that came with joining the single currency. In common with other struggling eurozone economies – Italy, Spain and Portugal – Greece’s elite treated the euro as a shield against turbulence in the foreign currency markets, forgetting that it is also a corset – which requires eurozone members to have flexible markets for goods, services and labour. The result is that these countries’ industries have lost trade competitiveness within the currency bloc. Their economies are weighed down by poor growth prospects and unsustainable fiscal positions.

The German government argues that if Greece – and the other South European countries – cut public spending and wages, they would strengthen their budgetary position and make their exports more price competitive within the eurozone. Germany and the Netherlands have successfully boosted their competitiveness within the eurozone by exercising such wage restraint. The South Europeans must now follow suit.

But the medicine that Germany prescribes for the struggling eurozone economies will not solve their problems. The reason is that it is impossible for every country simultaneously to act like Germany. Germany’s growth model over the past 15 years – eye-watering wage restraint, stagnant domestic demand and booming exports – has only been possible because other countries were not pursuing it. In effect, Germany was rescued from a prolonged economic slump by the profligacy of the countries whose behaviour it now castigates. If Germany’s growth model was exported to the whole of the eurozone (or, for that matter, to the rest of the world), the result would be beggar-thy-neighbour wage cuts and a global economic slump.

The German government is right to call for reform and greater responsibility in Southern Europe. But it must accept that this will inevitably have repercussions for its own export-led growth model. Yet it remains strangely reluctant to do so. It maintains that there is little it can do about the size of the country’s trade surplus with the rest of the eurozone, which accounts for three-fifths of its overall surplus. It rightly points out that its surplus is not a product of protectionism or currency manipulation. The surplus, it argues, simply reflects the fact that German firms make things that others want to buy. What, it asks, is Germany to do? Force its companies to make their goods less attractive, or encourage them to become less efficient?

The problem with Germany is not the quality of its exports. It is the chronic weakness of its domestic demand. Germans need to understand that the ultimate aim of economic activity is consumption. German wage restraint has boosted the trade competitiveness of local firms but it has also depressed domestic spending power. As a result, German consumer spending has barely risen for a decade. The weakness of the domestic economy, in turn, has made German companies reluctant to hire workers and most jobs created in the last decade have been low-wage ones. It has made people more risk averse, boosted savings and undermined investment. German workers need to take home a greater share of the fruits of their labour. They would then consume more of what they and others produce.

Can the German government really do nothing to raise disposable income or reduce the savings rate? It could have cut income taxes three years ago (when consumer confidence was strong) and helped engender a self-sustaining rise in consumption. But instead it opted to balance the budget. Even now, when consumer confidence is weak, tax cuts could stimulate consumption so long as they are targeted at those on modest incomes, who save little. Shortly after her re-election in September 2009, Chancellor Merkel announced plans to reduce taxes by €20 billion in 2011. Unfortunately, intense opposition to this move from within her government means that any cuts are now almost certain to be matched by cutbacks in spending. The government’s commitment to cutting the budget deficit to just 0.35 per cent of GDP by 2016 leaves scant scope for a lowering of the tax burden. Finally, the German authorities could refrain from portraying any rise in wage settlements as a threat to the country’s export competitiveness and hence growth prospects. Export competitiveness and economic growth prospects are different things.

The eurozone would also benefit from greater institutional integration. Unfortunately, there is no chance of any moves towards greater fiscal union, in which the stronger economies would transfer money to the weaker ones. Nor are any of the mooted alternatives likely to be much help. A European Monetary Fund would be a major innovation for Europe, but inadequate to address the challenges facing the eurozone. It might help the EU to manage crises, but it would not do much to prevent such crises arising in the first place.

What of economic government (or gouvernance économique)? Eurozone finance ministers issued a statement on March 15th saying that the unwinding of imbalances within the eurozone will require action by both deficit and surplus countries. But the German government has made it abundantly clear that the only binding mechanism it will accept will be one to enforce budgetary discipline, even going so far as to suggest that countries should be forced to quit the eurozone if they fail to abide by these fiscal rules. The German authorities will not sign up to any form of economic government that could require them to rebalance Germany’s economy.

Everyone stands to lose if current trends persist, starting with Germany. If the countries with large external surpluses will not or cannot rebalance their economies, the struggling southern member-states will find it impossible to extract themselves from the mire, irrespective of what they do: their fiscal positions, for example, will not improve if their economies contract faster than they can cut public spending. The result would be ongoing slump and fiscal crisis in the south, perhaps even spreading to France. This would severely depress Germany’s highly export-dependent economy, making it all but impossible to prevent a steep rise in the country’s public debt.

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