Look who’s Gloomy
Wolfgang Munchau has an excellent piece on today’s Financial Times, where he challenges the increasingly widespread (and unjustified) optimism about the end of the EMU crisis. The premise of the piece is that for the end of the crisis to be durable, it must pass through adjustment between core and periphery. He cites similar statements made in the latest IMF World Economic Outlook. This is good news per se, because nowadays, with the exception of Germany it became common knowledge that the EMU imbalances are structural and not simply the product of late night parties in the periphery. But what are Munchau’s reasons for pessimism?
- Rebalancing is happening only in the periphery, that through deflationary policies is reducing its current account deficit. The core’s surpluses are virtually unchanged
- As a consequence, the eurozone as a whole is moving from equilibrium to surplus. “In other words, the eurozone is adjusting at the expense of the rest of the world”.
- Finally, the most serious: This adjustment is not structural, but purely cyclical. The improvement in Spain’s competitiveness, for example, is mostly due to cyclical factors (deflation, drop of domestic demand, etc). Nothing that is likely to persist once growth resumes.
Munchau then joins the IMF in arguing that the necessary adjustment, especially if it keeps being asymmetric as it has been until now, would need to be immensely larger than what we observed so far. The solution then needs to be a substantial reversal of export-led growth in Germany and in the core (very unlikely), or a system of transfers of some sort, a fiscal union (even more unlikely). This explains why Munchau is so pessimist.
Readers of this blog will not be surprised by my agreement with Munchau. Rebalancing within the EMU is happening through deflation and synchronization of fiscal policies, in the core and in the periphery alike, through procyclical austerity. The ensuing sluggish growth has made adjustment harder and – what is worse in a medium term perspective – it has triggered further divergence.
There is only one thing I would have written differently from Munchau: he does not focus enough, in my opinion, on the inherent flaws of the export-led model that – his article shows – Germany managed to force upon the rest of the eurozone. Not only there is an obvious fallacy of composition in this model. But, even more importantly, compressing domestic demand in the desperate research for price competitiveness risks suffocating the incentives to research and innovation that sustain growth in the longer term. Germany itself will likely be confronted with some of these problems in the future.
How should domestic demand be supported? In the core it is clear. Countries in good health should run expansionary policies and support widespread and substantial wage increases. These policies may be procyclical for them, but they would sustain the recovery for the eurozone as a whole, and eventually be beneficial for the core as well as for the periphery.
For the periphery, burdened by debt and deteriorated public finances, the recipe is more complicated. I suggested a few months ago that proper reallocation of tax burdens, even if revenue neutral, could increase disposable income of low and middle-income households, and boost domestic spending. The October 2013 IMF Fiscal Monitor reaches very similar conclusions based on solid analytical work. This is one of the issues that will be worth developing in the future.