European choices

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The article below is a guest contribution by Cees Bruggemans, Chief Economist of First National Bank.

Last week, the Euro area Purchasing Managers Index (PMI) rose for the second month in a row, topping out above 50, surprising market analysts who had expected 48.

It suggests no EU recession, or at least the possibility of already moving on, bolstered by late last year’s French output data and also this week by German IFO business confidence data (all perking up).

Yet on the very day of the PMI release the IMF released with the usual fanfare its latest world outlook, heavily revising down its global growth forecast from 4% to 3.3% with dire words for Europe.

This greatly added to the creative tension bearing down on that unhappy continent, with the IMF, as so many others, presumably inspired by the thought “why waste a good crisis?”

As usual, though, the IMF was six months late where events are concerned.

This doesn’t mean to say Europe is out of the woods. But the pain is mainly on the plain in Spain and other peripherals. The core EU may have slowed but is not necessarily sinking. As the latter carry the greater weight in the overall picture, it decides the overall colour scheme in the Eurozone.

So while Europe is bad, it is a tad premature for funerals.

Three articles in recent weeks drew attention, by former Fed Vice Chairman Alan Blinder, Bank of Greece Governor George Provopoulos and Portugal’s Carlos Moedas (secretary of state to the prime minister), each in turn emphasising just how very complex and challenging the European makeover is and will be and choices on offer.

In considering this, one should also keep in mind Italian prime minister Monti’s earlier reform announcements, and Spanish prime minister Rajoy’s intentions. The communality and interchangeability between is something to behold.


George Provopoulos, Governor of the Central Bank of Greece, highlighted a few home truths last week for those perhaps ignorant of what his country is going through and will still face.

It makes for shocking reading. But also, perhaps surprisingly, it makes for possible redemption and not via Euro exits either.

Greece is now in its fifth year of economic contraction, unemployment is surging, fiscal and current account deficits remain large and Greek borrowers are shut out of financial markets.

This is far worse than envisaged under the May 2010 adjustment programme. As Greece negotiates yet another adjustment programme, why did the first one go off track?

Firstly, implementation was slow and inefficient.

Secondly, fiscal consolidation based on spending cuts lead to a smaller economic contraction than ones based on tax increases. Yet Greek measures depended for 60% on tax increases and for 40% on spending cuts.

This mix reduced the incentive of businesses to invest by reducing after-tax returns on investments. Temporary tax increases still hold the economy back by creating policy unpredictability. Tax increases also reduced after-tax income, restraining consumption.

Government spending remained over 50% of GDP, reducing scope for private investment to boost exports and import-competitive goods and generate growth.

Worse, government scaled back public infrastructure investment most sharply, yet it is the key contributor to the country’s future economic growth.

Thirdly, the scale of fiscal cutbacks was large because of the size of the initial budget deficits. Such cutbacks were never going to be easy. Still, they were almost twice as large for Greek households in 2011 as for those in Ireland and more than twice those in Portugal.

Indeed, difficulties in implementing structural reforms, privatisation and measures to improve efficiency of tax collection exacerbated unavoidable pain. As a consequence these fiscal cutbacks led to a greater economic contraction than expected as not all interconnected parts of the programme were in place.

Fourthly, Greece has experienced a much bigger negative fiscal multiplier than other peripherals. Greece has undergone a larger fiscal cutback than Ireland or Portugal, but relative to the size of the cutbacks the economy has contracted more, as Greece is a relatively closed economy (any decline in demand hitting domestically produced goods more than imports).

This decline in demand for domestic production affects output more than if the economy were more open (with a greater share of imports in final demand).

Together these factors have produced a cycle of pessimism, cuts in private spending and negative growth.

The banking system, for instance, entered the crisis with sound fundamentals. But serial downgrades to sovereign debt last year led to deposit withdrawals (run on banks) and asset deleveraging (fire sales), feeding each other, compounding problems, exacerbating economic contraction.

Worse, there hasn’t been a thorough public discussion of the crisis and its implications, impeding the chances of winning and sustaining a broad-based social consensus.

Yet Provopoulos is hardly ready to throw in the towel, claiming the potential for economic growth is “vast”, suggesting the following solutions:

  • Move fast to implement bold structural reforms (not specified, but think Monti’s Italy), far-reaching privatisation and effective measures to combat tax evasion (also Monti’s Italy)
  • Fiscal cutbacks should involve 65% spending cuts so that the share of government spending in national output is reduced, allowing a competitive export sector to flourish
  • As growth resumes and tax collection rises, many of the recent tax increases can then be reversed.

Thus the Central Bank Governor of Greece at first highlights the sacrifices being made, and the mistakes, but suggests that yet more structural reform and the right actions will get Greece through this.

There is no mention of a quick exit from the Euro as a way of solving problems. So no matter the sage advice by so many outsiders, Greece seemingly wants to stay the course and reap the benefits of structural change within the context of a European Monetary Union as envisaged.


All this about a country whose outstanding sovereign debt in the crisis interim has risen steadily to a non-sustainable 190% of GDP, requiring a deep restructuring in order to bring this ratio back to a sustainable 120% of GDP by 2020 (and this outcome even then being questioned, for will the necessary structural reforms deliver the growth underlying such projections?).

As things stand, we are in the closing stages of a drama in which private debt holders are being invited to agree to a near 70% haircut, an exchange of old bonds for new carrying a coupon of less than 4%, and this done ‘voluntary’ in order to prevent credit default swaps (CDS) options being triggered.

Also, we witness the ECB vehemently trying to prevent haircuts on its holdings, as insisted on by the IMF, possibly creating the need for a slightly bigger second official bailout than the €130bn agreed earlier by Eurozone politicians.

With no guarantee that another debt restructuring may not be required at a later stage, with diminishing degrees of overall success likely as time goes by, and German calls this week for Greece to cede sovereignty over tax and spending decisions to a Eurozone “budget commissioner” for a certain period of time (“given disappointing compliance so far”).


Barely two days after the Provopoulos exposition in the Financial Times there was an attempt at global enlightening by Carlos Moedas, secretary of state to the prime minister of Portugal.

Writing in the Wall Street Journal last week, his analysis follows blow-for-blow (coincidental or not) the Provopoulos one of two days earlier (and indeed echoing Italian caretaker Mario Monti’s reform agenda for Italy published even earlier), except that Moedas highlights in no uncertain terms what is being achieved (and hardly covered in the global media) in reforming Portugal.

It makes for quite a story worthy of global attention.

There are three parts to the Moedas analysis, namely external imbalances, domestic fiscal imbalances and structural reforms.

Regarding external imbalances, Moedas mentions Portugal’s current account deficit having been 9% of GDP in 2010, but estimating it at 7% for 2011, expecting 1.6% in 2012 and hoping for a surplus in 2013.

This progress is explained partly by contracting domestic demand (mirrored in a strong savings rebound) but also strong export performance (+7.3% in 2011).

This is described as quite remarkable, considering strained global conditions, and testament to the strong adaptability of Portuguese companies which, when faced with weaker demand in EU markets, are now tapping strong EM potential with linguistics ties to Portugal (Brazil, Angola, Mozambique – all booming commodity stories!).

Thus, according to Moedas, Portugal is showing a capacity to restore trade competitiveness within the constraints of the EU monetary union.

Regarding domestic fiscal imbalances, Moedas claims fiscal adjustment to be well under way. The structural budget deficit has been reduced from a 2010 peak of 11.4% of GDP to 7% in 2011, aiming for 2.6% in 2012.

This year the primary fiscal balance (excluding interest payments) is expected to be a surplus of 0.3% of GDP.

All this entails austerity measures and some economic contraction. But because 70% of the adjustment comes from spending cuts and 30% from revenue increases (compare the Provopoulos Greek lesson), Moedas emphasises that Portugal is minimising potential economic disincentives while simultaneously retrenching the size of the state.

Total primary expenditure (government, public sector?) was 48% of GDP in 2010 and is to be reduced to 42% in 2012. This should further contribute to a shift from non-tradable to tradable sectors and will eventually open the possibility of tax cuts.

Privatisation is proceeding. The sale of power company EDP raised €2.7bn, with more such revenue to come.

Regarding structural rigidity, Moedas mentions that Portugal is engaged in sweeping structural reforms, intended to eventually allow the country to emerge from the present crisis with better prospects for growth (better even than countries currently lacking in proper incentives and drive for change).

According to Moedas, Portugal is adopting a new competition law in line with best EU practice to better promote a level playing field in its economy and reduce rent-seeking. There is to be “acceleration of the transposition of the services directive”, reducing long-standing barriers to a more open economy. Also a new insolvency code focusing on restructuring viable companies and bringing insolvent ones to a rapid end.

Portugal is restructuring state-owned enterprises, eliminating redundant services and management positions. It has merged different tax collection agencies to save costs and improve tax collection.

(Despite a shrinking economy, tax revenue increased by 4.6% in 2011).

Last week, the Portuguese government and its social partners reached agreement about labour reform (with the labour dispensation historically very rigid).

Indemnities for dismissal will be reduced and the process simplified. There will be reduction of vacation days and holidays, generating more competitive unit labour costs.

According to Moedas, all these changes reflect strong social and political consensus about fiscal discipline and need for change. Thus Portugal is seen as restoring its competitiveness despite all the current headwinds and this is why it believes its growth will return.

A powerful analysis indeed, matching Provopoulos point for point (and Italy’s Monti), but going further in showing what has been achieved in Portugal to date and is intended to be achieved within the next two years.


It is a pity there was no mention of any intended changes to Portugal’s education system with the aim to greatly improve its functioning and results, something explored a year ago in a Comment (“Education”, 26 April 2011 ).

Far more seriously, even as the Moedas article was being penned, the past week saw growing market sentiment that Portugal poses longer-term risk to the ongoing debt market rally driven mainly by the ECB’s €489bn December super repo and the way this has eased bank funding.

There is apparently growing market conviction about Portugal’s perceived inability to access bond markets within two years and that this will compel the IMF to renegotiate its aid package before the end of this year.

The official sector may need after all to provide a second aid package. Also, there is high risk of falling behind on ambitious deficit targets, given optimistic growth assumptions. The CDS markets are pricing in 50% probability of default over two years.

These market sentiments don’t seem to jell with the spirit of the Moedas analysis.


Spain appears to be lagging on all these scores, but that may just be timing. The new Rajoy government has had little time to prepare a thorough strategic reform plan, while important regional elections in Andalusia in March may be a reason to hold back on the cruelest intentions just a little longer.

Even so, Rajoy’s Spanish reform reportedly will have three parts, with the details to be revealed in the next few weeks.

First, austerity and deficit control, fully in line with the other peripherals.

Second, reform of the labour market and the inflexible collective bargaining system, equally in line with reforms elsewhere.

Third, cleaning up bank balance sheets burdened with €176bn of bad or doubtful property assets while encouraging more mergers and restructurings.

This Spanish reform agenda is clearly something to watch in coming months.


Alan Blinder, professor of economics at Princeton and a former Vice Chairman of the Fed under Alan Greenspan, gave his analysis of what ails Europe structurally and what hope it has to right the ship in a Wall street Journal article last December.

According to Blinder, Europe has two gigantic problems. The most visible one is the sovereign debt and banking crisis. The slower-acting but most intractable one is lopsided competitiveness within the Eurozone.

Regarding the sovereign debt and banking crisis, the immediate problem proving such a challenge is that the Eurozone isn’t a country.

There are now 17 sovereign nations signed up for currency union, but without first homogenising their budget policies, tax systems, bank regulations or much else.

And they joined in union without creating a central government strong enough to impose cross-border discipline or finance large cross-country transfers.

In order to succeed, the Eurozone countries would have to get both lucky and good. For about a decade they did.

But luck does eventually run out on all of us. So-called ‘asymmetric shocks’ do happen now and then, and are the Achilles heel of currency unions.

Put plainly, if some member countries do well (and/or pursue sound policies) while others do poorly (and/or pursue unsound policies), locking them into a single currency is like a camel and donkey unequally yoked.

Ere long, the weaker partner becomes uncomfortably squeezed. Greece was squeezed first over the issue of sovereign debt. But it could have been something else and someone else at any time that set crisis mode rolling.

A weak economy has three ways to fight back: loosen monetary policy, loosen fiscal policy or let the currency depreciate. If the currency is floating, the market does this automatically.

Crucially, membership in the EMU (European Monetary Union) forecloses two of these escape hatches (monetary loosening and currency depreciation, except as a bloc against the outside world through ECB conducted policy and/or loss of market trust).

It only leaves fiscal policy. Once a member country stretches its borrowing to the limit, as Greece did, that route is also closed.

What then happens is a Greek tragedy (depression).

If monetary stimulus, fiscal stimulus nor currency depreciation is possible, when does depression end?

It may take quite a while.

Real GDP in Greece is already down by 12% and is still falling, according to Blinder. After Greece, markets started turning on other weak Eurozone countries: Portugal, Ireland, Spain, Italy and beyond.

At their 9 December 2011 summit, the 17 Eurozone countries pledged to pursue fiscal discipline, with tighter enforcement than previously. That agreement is about forestalling future crises (though it is also intended to impress markets and eventually win back trust and confidence).

As things stand, severe fiscal austerity all over Europe will deepen the recession. Much reliance is in the meantime put on the ECB to prevent the worst through super supportive bank liquidity provisioning (and limited and temporary sovereign debt purchases alongside ESM lifeboat and IMF actions).

If this debt-and-banking crisis is the “easy” EU problem, the huge other EU problem is competitiveness. It is far more basic and looks less solvable, according to Blinder.

To see why, do appreciate the two fundamental determinants of exchange rates:

  • Firstly, productivity in different countries (faster productivity growth should lead to a rising exchange rate)
  • Secondly, prices/wages in different countries (lower inflation should lead to a rising exchange rate)

For a currency union to succeed, its member nations need to register approximately equal productivity growth and approximately equal wage and price inflation.

The camel and donkey yoked together need to be about equal in performance characteristics. Ideally, both over time are transformed into evenly matched oxen ……….

How is the Eurozone faring on this score?

In principle, the ECB’s common monetary policy should approximately equalise inflation rates across all the member countries. In practice it hasn’t.

Germany has had the lowest inflation, followed by France. Highest inflation has been in Greece and Spain. While these inflation differentials are not gigantic, they are cumulatively large enough to strain a system of fixed exchange rates.

When it comes to productivity, things are worse. Germany has pulled away from the pack, partly because of thorough labour market reforms in the last decade. Since 2000, German unit labour costs have risen about 20%-30% less than unit labour costs in the other Euro countries.

That gap has left Germany with a large intra-European trade surplus while most other countries run deficits.

Thus Germany has acquired a seriously undervalued currency by locking into a fixed (Euro) exchange rate with Greece, Spain, Italy and others.

There are three ways for the other (peripheral) countries to close the LARGE competitive gap with Germany.

Firstly, Germany volunteers for higher inflation than its Euro partners by implementing a large fiscal stimulus or ending its wage restraint.

The whole world understands that’s not going to happen, not after what Germany has been through and has achieved.

The European convoy is not going to set its standards relative to the weakest stragglers. It is the fastest ships that need to be seen as role models and to be imitated as such.

Secondly, the other countries engineer German-like productivity miracles through structural reforms while Germany relatively speaking stands still.

This is an option that would take many years to bear fruit while all the while having to face down impatient markets demanding immediate results.

Thirdly, the other countries can engineer a relative deflation, meaning a prolonged decline in both wages and prices relative to Germany, which would be incredibly difficult and painful to achieve, and generally happens only in protracted recessions.

Blinder considers the first option non-negotiable, rightly so. He has difficulty with the second option (for can the peripherals really outperform Germany for a while, converging at least part of the way?).

For these reasons he thinks the third option will be the most likely way out.

Interestingly, Blinder doesn’t offer the way out so many others can’t stop talking about, namely the weakest peripherals default and opt out of the Euro, massively devaluing their new currencies.


In essence, like Provopoulos and Moedas (and Monti and Rajoy), Blinder sees nobody opting out of the Euro.

In this matter all three authors differ fundamentally from others, such as Michael Spence of New York university and Kenneth Rogoff of Harvard, who feel that some countries (especially Greece and possibly Portugal) have to face up to an Euro exit.

Be that as it may.

Amid all the potential pain for peripheral countries somehow having to make the grade, and be turned into oxen and matched in yoke with the core Eurozone countries, there is one bit of good news.

The worst placed peripherals have enormous backlogs in terms of productivity and have liberally allowed cost and wages to overshoot Germanic standards.

There is therefore a large catch-up potential for their productivity to improve PROVIDED they get real with their structural reforms and overcome decades/centuries of institutional rigidity.

That’s half of the way home. The other half could be through a relative deflation by suppressing prices and real wages.

Indeed, very painful, but the lack of past discipline may make the first gains more easy to be achieved once new rules come to apply through institutional reforms.

If it can apply to core Europeans, especially to Germany these past twenty years and to the UK under Thatcher in the 1980s, it shouldn’t in the long run be precluded from applying to most, if not all, European peripherals as well, given enough time to make the adjustment, however painful this will still be.

None of this is claimed to be easy.

But if majorities everywhere don’t want to opt out of the Euro, as polls show and these gentlemen suggest by omission, and Germany isn’t going to give up its own hard-won competitive gains, it is the combination of options two and three over a decade or longer that is going to force far greater Continental structural convergence than seen to date, finally underpinning a more viable monetary union (alongside the fiscal governance rules taking shape).

As to the baying markets demanding instant convergence or immediate fragmentation and exiting from the Euro, it will be up to the ECB (and the ESM lifeboat, with or without assistance from the IMF) to buy time.

Institutionally and time wise, all this is feasible if all are determined that exiting isn’t an option.

And so, it seems, it has been decided, though the road will be long and arduous and full of danger. There could still be many ambushes, not least from within but also from without.

Select References

Alan Blinder, “The Euro Zone’s German Crisis” Wall Street Journal 14 December 2011

Carlos Moedas, “Portugal is beating headwinds”, Wall Street Journal 26 January 2012

Daniel Yergin, “The Real Margaret Thatcher Story”, Wall street Journal 26 January 2012

Chris Giles “Pessimism hangs in mountain air” Financial Times 25 January 2012

George Provopoulos, “Timely Greek lessons on the eurozone crisis” Financial Times 24 January 2012

Peter Spiegel, “Call for EU to control Greek budget”, Financial Times 28 January 2012

Victor Mallet, “Spaniards grow edgy for reform Rajoy promised” Financial Times 27 January 2012

Source: Cees Bruggemans, First National Bank, January 30, 2012.

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