Ifo Viewpoint No. 133: A Euro Sabbatical
Munich, 16 March 2012
Under substantial external pressure, the Eurozone’s crisis-hit countries are, at long last, bringing themselves to make painful cuts in their government budgets. Salaries are being slashed and public employees sacked to reduce new borrowing to a tolerable level. And yet, competitiveness in Greece and Portugal, in particular, is not improving.
The latest Eurostat figures on the evolution of the price index for self-produced goods (GDP deflator) show no tendency whatsoever in the crisis-stricken countries towards real devaluation. But real devaluation, achieved by lowering prices vis-à-vis their Eurozone competitors, is the only way to re-establish these countries’ competitiveness. A reduction in unit labor costs can also increase competitiveness only to the extent that it actually results in price reductions.
After all, it was price inflation in the crisis countries, fuelled by massive inflows of cheap credit following the introduction of the euro that resulted in their loss of competitiveness, ballooning current-account deficits, and accumulation of enormous foreign debt. Now that capital markets are no longer willing to finance these deficits, prices should be going into reverse, but this, obviously, is not happening.
In 2010, inflation in some of the crisis countries lagged slightly behind that of their Eurozone competitors. The latest Eurostat figures for the third quarter of 2011, however, are already showing a different picture: the price level in Portugal and Greece has remained practically unchanged over the course of the year, and in Italy and Spain it even rose slightly (by 0.4% and 0.3%, respectively).
Only Ireland continued on a path of rapid deflation – as it has since the country’s real-estate bubble burst in 2006 – with a relative price decrease of 2.2%. On the whole, Ireland has become cheaper relative to its Eurozone competitors by a total of 15% over the course of the past five years. This internal devaluation is paying off: while Ireland was still running a current-account deficit of 5.6% of GDP in 2008, the European Commission expects 0.7%-of-GDP current account surplus for 2011. True, much of this is mere interest relief, given that Ireland was able to repay its foreign debt with self-printed money, for which it pays only 1% interest. However, Ireland's big trade surplus did improve further.
Ireland owes much of this turnaround to its efficient export sector, whose supporters were able to enforce a political U-turn. Greece, on the other hand, is under the influence of a strong import lobby. As the Greek economics minister, Michalis Chrysochoidis, has said, this is attributable to European Union subsidies, which drove entrepreneurs to follow the easy money into the import sector.
Now these importers form a powerful bulwark against any policy that causes deflation, even though lowering prices – and thereby redirecting Greek demand from foreign to domestic products and helping tourism – is the only way to put the Greek economy back on its feet. Since Greece’s current-account deficit as a share of GDP was three times higher than Ireland’s, the Greek prices would have to fall by about half to achieve the same kind of success. It is inconceivable that Greece could manage that within the Eurozone without widespread social unrest, if not conditions approaching those of civil war.
But it isn’t just importers who are blocking real devaluation. Unions, too, are resisting the necessary wage reductions, and public and private debtors fear the prospect of insolvency if their assets and revenues are assessed at a lower value, while their debts remain unchanged. The situation is intractable.
Many people see debt relief and socialization of debts as the only way out. This help has been given. The new agreement of last week gave Greece a relief of 237 billion euros, about 30% more than the Greek net national income, which is on the order of 180 billion euros. But such help only entrenches the wrong prices – and thus the lack of competitiveness. The debts would re-emerge like a tumour, growing year by year, while undermining the creditworthiness of stable Eurozone countries.
If that happened, the euro would eventually collapse. Only a price reduction would create current-account surpluses and enable the crisis countries to pay off their foreign debts. It is time for Europe to come to terms with this remorseless truth.
Those crisis countries that do not want to take it upon themselves to lower their prices should be given the opportunity to leave the Eurozone temporarily in order to devalue prices and debts. In other words, they should take a kind of euro sabbatical – a proposal that has now also been taken up by American economist Kenneth Rogoff.
After the ensuing financial thunderstorm dies down, the sun would come out again very quickly. The creditor countries would have to shoulder big losses from write-downs, but they would still end up with more than they would have gotten had the crisis countries remained within the Eurozone, because these countries’ new prosperity, gained by leaving, offers the only chance of recovering any assets at all.
Professor for Economics and Public Finance
President of the Ifo Institute
Published under the title “Die Preise senken!”, Handelsblatt, No. 45, 02/03/04 March 2012, p. 80, and under the title “A Euro Sabbatical”, by Project Syndicate.