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2018-03-08Macro `n Cheese

The Euro crisis – A reminder

A gentle reminder from Roger that the Euro crisis is far from over.

Over the past few months and years, many a prominent Euro-sceptic have been forced to admit that the politicians of the Euro Area have proved considerably more devoted to the European idea than anyone would have thought possible. Our Chief Economist, if not as prominent, is at least persistent (correlation or causation, we wonder?). And while he seems pleased to see an improvement of economic conditions and hopeful the expansion might continue for some time, to Roger, the Euro crisis is far from over.

The basics

It has become increasingly popular to write “A Primer”, as in “Leprechaunomics – A Primer”. But what do you call it when you have written extensively on a subject and, arguably, still think you have something to transmit?

– Hmm. Anyhow, in this “reminder” (!) I thought we would take a look at Euro Area developments from the perspective of the Euro crisis that formed in the wake of the global financial crisis.

At the onset of the Euro crisis I declared (for the few willing to listen) that the Euro crisis has only 2½ solutions, no more, no less. What I was suggesting was that either the Euro Area governments forged a much tighter fiscal bond or the Euro Area (and EU) would simply and eventually be torn apart. The final and most plausible half-solution, also known as “kicking-the-can-down-the-road” or “muddling-through”, would imply a slow, drawn-out process where cost-differentials were restored in the most painful manner possible. Eventually, the policies needed under the half-solution would provoke a political backlash that would align policies with the first or, more probably, the second solution.

This line of reasoning, I think, is also what most other sceptics have been alluding to, at least up until recently. So, what’s changed? To understand that, let us first take a look at a couple of basic charts.

Macrobond Document Macrobond Document
Note: Forecasts are the latest EU Commission staff forecasts.
Chart 1 a & b: Ouch.

Considering that it was on the 26th of July, 2012 that Mario Draghi declared “[…] within our mandate, the ECB is ready to do whatever it takes to preserve the Euro. And believe me, it will be enough.”, it is hard to interpret the above left chart as ECB-policies being anything but a roaring success.

– But it did take a lot, as can be seen in chart, above right. Of course, Germany is now close to its pre-crisis trend, but Italy is sporting an “output gap” of more than 20% and Spain, despite growing strong over the past few years, falls almost 30% short of its pre-crisis trends. If my back-of-the-envelope calculations are anything to go by, this would amount to an income-shortfall of the equivalent of more than EUR 7000 per Spaniard and more than EUR 5000 per Italian.

You would be excused for thinking that this massive welfare loss should at least have bought some improvement in competitiveness1. Sure enough, post-crisis, unit labor costs (ULC) have fallen on trend vis-à-vis Germany in both Italy and Spain, implying that competitiveness has been improved, particularly in Spain. These developments are also mirrored in the current account balances, that have moved from sizable, even gargantuan, deficits to surpluses in both Italy and Spain.

Macrobond Document Macrobond Document
Chart 2 a & b: Competitiveness has improved. As have current account balances

That’s nice! The Euro Area is finally on a roll again! Some improvement in competitiveness and, voilà, current account surpluses! I am being ludicrously behind-the-curve-pessimistic, aren’t I?

– Before I completely roll over and admit to being a reactionary ‘old FART’ 2, let’s also agree that catch-up (in terms of welfare) within a common currency area should come about via increased productivity (and wages) in the poorer countries’ export sectors, which would then spread throughout the domestic sectors of these economies. Indeed, this could warrant a more sanguine view of increasing ULCs, at least if the poor countries’ current account balances are positive. And, if nothing else, it makes it considerably more difficult to say at what level of relative ULC Spain and Italy “should be”.

1When speaking about competitiveness I prefer nominal ULC as it captures both cost and price competitiveness whereas real ULC is a measure solely of cost competitiveness or change in wage share. Note, however, that I also refrain from taking “Unit Capital Cost” into account, which I probably should given the post-crisis shift in risk premia for, i.a., Spain and Italy (vis-à-vis Germany). 2If you ever wondered, it’s an acronym for: old, “Fat And Really Tired”. Really!

In the chart above, left, we see that nominal ULC is heading down for both Italy and Spain (compared to Germany). For Italy, so is real ULC, which implies that the wage share (of output) is also falling relative to Germany. Taken together, lower real, and nominal ULC do not only underline that Italian productivity and wage growth is lower than in Germany, but it also means that profits are being squeezed in comparison with Germany. Considering the very weak Italian GDP-growth it is probably safe to say that this is true also in absolute terms. In Spain, productivity growth has more or less kept pace with Germany, hence the stabilization of real ULC. But as nominal ULC continues to fall it nonetheless implies that profits are under pressure also in Spain. – Needless to say, such developments are not conducive to a view of restored competitiveness.

Macrobond Document Macrobond Document
Chart 3 a & b:It’s not a family affair

Indeed, this impression is furthered when studying the trade balances3 with countries inside and outside the Euro Area. We can clearly see that the bulk of the strengthening of Italian and Spanish balances post-crisis comes from extra-Euro Area trade balances (especially for Italy), and that the intra-Euro Area trade balances are, at best, close to balance. Had the restoration of competitiveness (via productivity or cost-cuts) been ‘sufficient’, we would expect to see Spain and Italy moving into intra-EA surpluses. Instead, and touching on last week’s post, what the upper right graph suggests is that most of the improvement is due to stronger external demand and a weak currency. Quite likely, the very strong, partly currency induced, performance of German trade (i.e., exports) has also given rise to knock-on effects on, e.g., Spanish and Italian suppliers.

3Going full conspiracy theorist, it is interesting that, e.g. for Spain, it is so hard to get long(er) time series with coherent and detailed Current Account data for the past few years (part of, i.a., the EU:s Macro-Economic Imbalance toolkit), but not for trade stats (not part of the toolkit). Just saying.
Macrobond Document
Chart 4:The ‘more real’ the FX-index we study, the weaker the Euro.

To be certain, the EUR might come across as strong in nominal terms, which is currently debated, but in real terms the EUR, nonetheless, seems balanced. And from a post-crisis perspective the EUR is even a tad weak, and, trending weaker (despite the uptick during last year).

In conclusion, the above goes a long way to explain why I expect trouble ahead. The muddle-through-solution will work as long as external demand is strong and/or the EUR is weak. When the next recession hits, what could reasonably be expected to stand between the Euro Area and a new Euro crisis is if very far-reaching reforms to improve productivity (i.e., labor market reforms) would be enacted and/or tighter fiscal integration could be achieved. This is also why I think that the Italian election threw a spanner in the works and why the lack of direction in Italy might prove more important than what is generally acknowledged.

Contrary to what you might believe, I do think that fiscal integration (and risk sharing is) a good idea, at least better than letting the Euro Area collapse. The necessary labor market reforms, and alignment of wage growth closer to productivity growth, which many North-European countries seek from their South-European brethren could perhaps even be incentivized via promises of increased integration. Put another way: I have high hopes on Macron-Merkel (“Mackerel”?)!

Is it warranted? – Now, that is an altogether different question. In particular, I think it boils down to the balance of power in two important aspects.

Macrobond Document Macrobond Document
Chart 5:The Euro Area terror balance

Germany is already conceding a lot of common Euro Area risk via the Target2-system, and an overt guarantee of all Euro liabilities might be too much to bear, even for all the German economic might. Not to mention that any fiscal, democratic, integration would probably be to the tune of a Bolero rather than a steady waltz.

I remain a sceptic.

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We don’t usually have views and opinions about economic and financial states of affairs, (not ones that we express publicly as a company, anyway). We do believe, however, that people can and do appreciate a variety of perspectives. What you’ve just read is the perspective of our resident chief economist. While we think he’s very smart, Macrobond Financial does not expressly endorse the views he presents here. And, as the old adage goes, you shouldn’t believe everything you read (not without finding the data, performing a few analyses and presenting it in a nice chart). We want to make it clear that we are not offering this information as investment advice. That being said, if you have the application you can easily check everything that’s mentioned here, and decide for yourself. If you don’t have the application, now you have a great reason to get it.