"The Street Light" responds to my post on Italy and Spain. Street lights in Malta by charakag
Kash Mansori provides his take on competitiveness and the problems of Italy and Spain in a post on his blog “The Street Light”. He raises some valid points, but I still disagree on four aspects: data of the past, Germany’s central bank, Germany’s gain from being in the Euro and German policy during the devaluation.
1. Past data
You shouldn’t reason from past data on something that is almost entirely a forward-looking issue. Past budget deficits or current debt to GDP ratios tell you very little about the sustainability of debt. The future debt burden and the future capacity to pay are what matters.
Italy’s growth prospect is bleak, it hasn’t even started to devalue internally, it is ageing at a tremendous speed and it will have a huge debt burden; Spain has a lower debt burden, but had a construction sector equal to almost 1/6 of the whole economy, a banking problem of unknown size and a mind-boggling unemployment rate of 21%. The internal devaluation that lies ahead of Spain is gigantic.
This is not to say that Italy and Spain are necessarily insolvent, but doubts about their solvency are more reasonable than proponents of illiquid-but-solvent arguments usually admit, and Kash is not exception.
2. Germany’s central bank
Kash argues that Germany is not under bond market pressure because it has its own central bank. What he means is that everyone expects the ECB to backstop a fall in German bond prices and therefore they don’t fall. I am not convinced, at least for the current situation.
A sovereign default by Germany would be against very deeply rooted convictions of the German public. It is no surprise that Gemany introduced a constitutional debt brake based on a party-wide consensus at a time when nobody was talking about sovereign defaults in Europe at all. Germans hate sovereign debt and inflation, and markets know this. Moreover, Germany has already devalued internally and its growth prospect is not bad at all.
Thus, there are plenty of more obvious reasons for Germany’s current position on the sovereign debt market. They, admittedly, don’t fit so well with Kash’s overall position on the Euro crisis.
3. Germany’s gain from being in the Euro
Kash is a prominent voice that suggests that the Euro has benefited Germany before this crisis. For instance, he writes:
The core eurozone countries like France and Germany were in the driver’s seat when it came to setting up this system, and they were happy to take advantage of the common currency when it was to their benefit. They now need to recognize that the responsibility for fixing this mess should really rest largely with them.
And yet he seems to be aware of the fact that Germany had to painfully devalue internally over 8 years. Anyone else noticing the contradiction here? To paraphrase Kash’s statement: Germany benefited from the Euro before this crisis, and the periphery is benefiting now. Doesn’t make sense, does it?
So let us recap a few things here. First, the benefits of facilitated trade were shared by everyone in the Eurozone – not only, in fact not even to a larger extent as is commonly suggested, by an exporting nation like Germany. Second, the other countries consciously traded the ability of adjustment through their exchange rates for lower interest rates, the Euro was not forced on them. The responsibility of fixing this mess should rest with everyone who participated.
4. German policy during the devaluation
As Kash rightly points out, the internal devaluation in Germany happened under pressure. But this supports my argument: as I have said before, pressure is probably needed for a quick adjustment. The 2000 stock boom delayed German adjustment to some extent, and an unconditional liquidity support by the ECB wouldn’t help much either in that respect.
How, then, can we keep up the pressure on Italy and Spain when the ECB is committing itself to buy unlimited amounts of debt? Am I the only one who sees the difficult bargaining game here?
And can Italy and Spain pull it off, once they are forced? I don’t know and it surely is hard. But unless the answer to this question is an unequivocal “yes”, these countries are not solvent. Quite frankly, I am astonished that Kash writes that Italy and Spain are “quite clearly … the victims of a self-fulfilling illiquid-not-insolvent sort of crisis”. Nothing is clear about that.
Let me end with a Dani Rodrik quote from 2010, being asked what Spain needs to do:
First, expenditure cuts are not going to do the job on their own, unless accompanied by policies targeted directly at improving competitiveness.
Second, “structural reforms” (which in the Spanish context means largely labor market reforms that aim to reduce firing costs and decentralize wage bargaining to the firm level) are not a substitute for competitiveness policies. Insofar as they eat up political capital, they may even backfire in the short-run.
Third, there are no easy solutions to Spain’s competitiveness conundrum. But the least bad solution is to engineer an economy-wide reduction in nominal wages and the prices of services (utilities, etc.) through some kind of social compact.
Easy? No. Any other practical alternative to a prolonged period of recession and high unemployment? Probably not.
That would be the kind of commitment or signal we need. As long as people keep telling Spain (Italy) that they are the victim of a self-fulfilling panic, that it is in fact Germany’s and France’s fault that they are where they are, and that it is Germany’s fault that the Euro crisis is not long solved, it will be harder to convince the people in Spain (Italy) what needs to be done.
@ kantoos:
In addition to your point 1) (Past Data) one could argue that any internal devaluation will almost definitely hurt an economy’s GDP at first, which in turn can be expected to push up the economy’s debt level.
The result of both factors will be a certain growth in the economy’s debt-to-GDP ratio before the positive effect of the internal devaluation kicks in, which is depending on the speed of respective policy implementation; so a need for internal devaluation almost automatically translates into rising future debt-to-GDP level.
In a nutshell it could be said that if a nation needs internal devaluation, it’s mid-term solvency would actually depend on:
a) the level of internal devaluation necessary
b) the speed at which such devaluation is implemented
c) the level of debt already in place.
All of these factors do not look too pretty for some european nations – or is this too simple?
@ jopa
No, I think you are getting the essence of the problem exactly right: these are the factors (and they depend on pas data, but in a very different way) that will determine the fate of some of the countries in the Eurozone. And it doesn’t look good for GR, ITA; ESP, POR.
I do not understand this obsession with competitiveness and internal devaluation. First, this can work if you have a significant potential for exports and can bring in foreign demand. Even then, the devaluation needed to get a significant price advantage is huge compared to what is socially achievable. If, on the other hand you mean, by “competitiveness”, fixing the balance of trade by reducing imports, what you are calling for is basically a reduction of consumption that will first and foremost hurt the domestic economy.
Second, this stuff only works if you are the only one doing it. If the whole periphery has to undergo devaluation, all you’ll get is a general reduction of income with a public (Italy, Greece) or private (Spain) debt overhang: congrats, you have engineered your own EZ-wide debt-deflationary situation. 30% unemployment good enough ?
Last, Germany managed its “devaluation” by limiting wage growth over a decade in a context of 2% inflation. With 1.5% being the new ECB normal and rapid action required, there is no way to pull that off for peripheral countries. As far as a “social compact” goes, you’ll never shove a reduction of wages down people’s throat “for the sake of the economy” when they have mortgages to pay and a nasty feeling of getting screwed in the deal. Especially when more and more of them realize it doesn’t make sense anyway.
An adjustment is needed in the relative price levels and capital flows in the eurozone. The only way it can happen is through increased inflation in the EZ core (yes, that means Germany among others). Until everyone understand this, we are all doomed.
I agree with your analysis, especially as regards inflation in the Eruoepan core. But doesn’t this suggest that the emphasis on competitiveness and internal devaluation is justified? Without these channels of adjustment the euro area cannot function.
@ To
Your sarcasm is unwarranted. I am a big fan of a higher inflation target. But the chances are low that we will get it.
And yes, it will be a debt-deflation situation, but as you can see in Greece, the solution then is to write down debt. What you are suggesting is the same as deflation plus writing down debt.
Henry Kaspar will have a post tomorrow on “we cannot all devalue”, so I leave that for now. As well as “you need potential for exports”.
Sorry for the angry tone. I just don’t think devaluation on the scale and in the timeframe required is achievable either. Maybe with massive debt writedowns it could achieve something, but given the time it took to sort-of-fix the Greek situation (3% of the EZ GDP, right ?) I don’t see a grand jubilee happening. The scale of the undertaking is just beyond the productive capability of the European political bartering industry. Maybe we should start judging the likelihood of potential policies by their cost in Merkozy-hours….
So, in the end, we are left with…?
@ To
Don’t worry, I am just as frustrated as you are. But exactly this is the question: what are we left with? “Liquidity” support to insolvent countries? Then what? Let’s continue this discussion tomorrow on Henry’s post, there is lots of material on these issues once again.
Hmmm… No mention of capital flows whatsoever in this post -whereas it seemed to me these were at the core of Mansori’s argument, especially when it came to both German competitiveness and German profits from the Euro. Wonder where all that capital came from? Outer space, maybe?
Also, call me dense, but if we can’t all devaluate at the same time, then how come we can all be more competitive at the same time? Isn’t there the same logical problem at the heart of both propositions?
But, hey, what do I know about compretitivity – I am French!
@ pg
With “under pressure” I meant that the German devaluation happened because of captial outflows. I thought that was clear, sorry.
And the loss in competitiveness is of course due to massive inflows of capital (and its use for unproductive purposes).
The compeititveness is a funny thing, I know. My definition of competitiveness is given here (http://kantooseconomics.com/2011/05/03/competitiveness-dani-rodrik-edition/), if you are interested. Do visit tomorrow as well for Henry Kaspars post on the issue.
Thanks for the answer, and do not apologize: I am not an economist, so I may well read you wrong, and it’s assuredly not your fault.
I am a historian though, so kinda interested in past data -and if I read your definition of competitivity right, then a cash-poor, peripheral country in a monetary union with cash-rich countries can remain competitive only by enforcing strict State control of capital inflows to make sure they don’t end up funding “unproductive” (your words) ventures (certainly in the case of Spain channeling it all into housing was not a government decision, was it?). Or was there another possible policy? Because if there was not, then aren’t you arguing that the EZ never should have been created in the first place, and the PIIGS should never have accepted to enter it?
Will read tomorrow as well, I promise.
PG
It does not help blaming the involved countries for failure or gaining, shifting the burden into one direction or the other or demanding this or that before this or that will happen.
Rather:
>The responsibility of fixing this mess should rest with everyone who participated.>
This is the only reasonable approach to solve this mess.
There is no way around that Italy, Spain and the other peripheral euro members must adjust so much that they become competitive. This is their job and includes what D. Rodrik said about Spain. It applies to the rest of the periphery too.
No question that this creates a lot of hardship showing at start in a negative GDP development that seems to label the process counterproductive. Since it cannot be different, there is no argument against it.
The argument for it: The triple A-core has to support the effort by guaranteeing financing and thus liquidity. If the peripherals reduce their imports from the core, then the core has to adjust.
Fast solutions are not possible and impatience on both sides would impair the process.
If ALL parties ACT on this basis, then discussions about illiquidity and solvency or self-fulfilling crisis are superfluous. Markets would recognize the development to the better and honor this by falling interest rates for government bonds which amounst to not less than cost reduction for public financing.
We would talk about self-fulfilling stabilization with relief for all involved.
A word to Germany:
>A sovereign default by Germany would be against very deeply rooted convictions of the German public.>
More than this: It would be against the interests of a great part of the German public.
Germans are underinvested in real estate and in stock. Instead: 82 million Germans own more than 90 million capital live insurances which by regulation are invested to more than 90% in bonds. A great part of these bonds should be German government bonds. So Germans are very concerned about the debt situation of the country. At present a majority is against tax reduction and favors instead debt limitation.
@Kantoos,
You may feel that this is largely unrelated to your post, but it is, as you will see at the end.
For some reason (convictions? rewards?) lots of people (like the one you picked here) write quasi plausible stories that tend to (1) treat the EUR as not irreversible -or discuss irreversibility with pity (2) misrepresent the underlying dynamics (caricaturical themes like lazy southerners, arrogant northerners etc or bogus economic history like here) and (3) belittle the EUR’s own solutions (4) glorify the “markets” (ie not “market”). No one ever discusses the convergence in GDP deflators taking place since 2008 partially as a result of Germany’s march towards potential output, partially because of the GFC’s effects on the availability of finance for inefficient construction.
Those were once the tools of propagandists..Careful analysis on a blog like yours mainly read by sympathetic and well informed intellectuals does not neutralize propaganda.
Propagandists tend to have regard for the interests of groups (that may be sponsoring them unofficially) and those interests are typically never mentioned in their work. I guess that the interests here are: (1) world trade (a EUR zone in crisis is more thrifty) and its effects on the US domestic recovery, tensions within the EU, and especially the position of the UK as an international financial centre (and captured by unregulated firms) mainly hosting foreign firms (a bit like Hong Kong or Singapore, very different from NY or Tokyo) and Chinese frustration with the weak EUR/USD exchange rate (there are no equivalents to US treasuries in the EUR zone, so it is much harder to manipulate the currency). The G20 will no doubt be again a forum for anti EUR rhetoric.
Fortunately for the EUR zone (that needs a strong EUR like the plague), the propagandists like this one, help creating the illusion that expectations about the inability of the EUR zone to “solve its problems” are plausible. Since the EUR zone lacks institutions that can make a credible commitment to any “solution”, and will continue to do so thanks to the German Constitution, that is in fact a rational expectation and the best hope for the peripherals to compete:
not with Germany, but with China, India, Poland etc,.. for direct investment in productive capacity.
All those countries must do themselves is lower their corporate taxes, raise VAT, lift the pension age and have a luxury tax on new housing. All the ECB as the sole central EUR institution needs to do is having a monetary policy that does not destroy those rational expectations about EUR weakness, as long as there is no wage-price spiral on the horizon outside Germany. Not easy for “Germany’s Central Bank”. But in the long run good for surviving German taxpayers.