20 April 2012

Dadush/Wyne: Is the euro rescue succeeding? An update

The current gyrations of sentiment over government bond spreads in the eurozone are generating much commentary. Yet this column argues they are diverting attention from the real issue – the eurozone periphery needs a big realignment towards the tradeable sector to reignite growth sustainably.

Can the tradable sector come to the rescue?

This appears least likely in Greece because its import-competing and export sectors are small and mostly based on tourism. Portugal is a little better off, with a bigger export sector, but one that confronts low-wage competitors directly. Ireland, by contrast, has large high-tech exports, amounting to 100 per cent of GDP, funded and operated by foreign multinationals. Ireland has a chance of reigniting growth, but may be hit again by large banking losses.

Spain has several competitive international firms and, unlike the other peripheral countries, has maintained its share of European exports over the past decade. But its export sector is small at roughly 26 per cent of GDP, its unemployment is already extremely high, and it still requires an enormous fiscal and housing sector adjustment. Its capacity to steer through more austerity thus remains in question.

Italy has a more diversified export base, and though its public debt is bigger, its housing, fiscal and labour market imbalances are not nearly as large as Spain’s. However, the adjustment in Italy is very recent and there is no sign yet of a trade-led recovery.

Policy: What to do?

One can imagine a vastly different political context where a €2 trillion “firewall” is erected, or the ECB provides unlimited support to governments, or even one where debts are mutualised. However, while in a terrible emergency political resistance to any one or to a combination of these may be overcome, none of these measures would deal with the underlying competitiveness issue, and may instead delay its resolution.

In any event, at present, there seems to be little alternative but to accelerate the adjustment process in the periphery through, for example, tax changes that incentivise exports and discourage consumption and imports, and more far-reaching labour and product market reforms. A less ideological approach to policy would also allow for some demand expansion in the healthy core, higher eurozone inflation, and a lower euro, all of which would ease adjustment in the periphery.

However, if all this and the fiscal cuts are not enough to restore competitiveness in the periphery (as has so far been the case), and unemployment keeps climbing, new approaches must be considered. Should failing countries be assisted in restructuring their debt and to leaving the eurozone? The complexity of doing so is daunting and great collateral damage would ensue, but there would at least be a light at the end of the tunnel. The alternative—depression, chronic unemployment, de-industrialisation and de-population of the afflicted countries—and even more concentration of European industry in its Northern regions, is not what anyone signed up for, or electorates will accept.

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