Home > EMU Crisis, Growth, Structural Reforms > Convergence, Where Art Thou?

Convergence, Where Art Thou?

September 2, 2015 Leave a comment Go to comments

A new Occasional Paper details the new methodology adopted by the Bank of Italy for calculating an index of price competitiveness, and applies it to the four largest eurozone economies.

I took the time to copy the numbers of table 3 in an excel file (let’s hope for the best), and to look at what happened since 2009. Here is the evolution of price competitiveness (a decrease means improved competitiveness):

2015_09_Convergence_1

I find this intriguing. We have been sold the story of Spain as the success story for EMU austerity as, contrary to other countries, it restored its external balance through internal devaluation. Well, apparently not. Since 2008 its price competitiveness improved, but less so than in the three other major EMU countries.

The reason must be that the rebalancing was internal to the eurozone, so that the figure does not in fact go against austerity nor internal devaluation. For sure, within eurozone price competitiveness improved for Spain. Well, think again…

2015_09_Convergence_2

This is indeed puzzling, and goes against anedoctical evidence. We’ll have to wait for the new methodology to be scrutinized by other researchers before making too much of this. But as it stands, it tells a different story from what we read all over the places. Spain’s current account improvement can hardly be related to an improvement in its price competitiveness. Likewise, by looking at France’s evolution, it is hard to argue that its current account problems are determined by price dynamics.

Without wanting to draw too much from a couple of time series, I would say that reforms in crisis countries should focus on boosting non-price competitiveness, rather than on reducing costs (in particular labour costs). And the thing is, some of these reforms may actually need increased public spending, for example in infrastructures, or in enhancing public administration’s efficiency. To accompany these reforms there is more to macroeconomic policy than just reducing taxes and at the same time cutting expenditure.

Since 2010 it ha been taken for granted that reforms and austerity should go hand in hand. This is one of the reasons for the policy disaster we lived. We really need to better understand the relationship between supply side policies and macroeconomic management. I see little or no debate on this, and I find it worrisome.

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  1. Gustavo Rinaldi
    September 3, 2015 at 3:46 pm

    In recent years, after 2009, the Current Account Balance of Spain, as that of Italy, Portugal and Greece is highly correlated with the GDP growth rate. The economies goes into recession, the c/c improves, the economy improves, the c/c goes downwards.
    That’s it.

  2. September 9, 2015 at 6:40 am

    Great piece. Yes, it’s been clear for some time that the trade balance of EZ countries is largely DEMAND-DRIVEN, not PRICE-DRIVEN. This point was made quite convincingly by the US economist J.W. Mason already back in 2012 in a series of articles (http://slackwire.blogspot.it/2012/05/do-prices-matter-eu-edition.html; http://slackwire.blogspot.it/2012/05/prices-and-european-crisis-continued.html; https://rwer.wordpress.com/2012/05/22/factoid-of-the-day-2252012-diminishing-german-competitiveness/; http://slackwire.blogspot.it/2012/11/what-drives-trade-flows-mostly-demand.html).

    More recently, it’s been reaffirmed – and empirically demonstrated pretty much beyond any doubt – by Servaas Storm and C.W.M. Naastepad in their great paper “Europe’s Hunger Games: Income Distribution, Cost Competitiveness and Crisis” (http://cje.oxfordjournals.org/content/early/2014/09/15/cje.beu037.abstract).

    The way I see it, the controversial implication – from a leftist standpoint – of all this is that, while cost-cutting and internal devaluation is clearly useless in improving a country’s competitiveness and boosting exports, it IS a pretty effective way – albeit painful and overall very socially/economically damaging – of addressing trade imbalances, by reducing demand/imports. By the same token, while the fact that trade flows are largely demand-driven supports the position that exiting the euro and devaluing one’s currency would not in itself improve a country’s competitiveness, it does also point to the oft-ignored fact that currency devaluation might be a *less painful* way of reducing imports – arguably, the only way of addressing the trade deficit of EZ countries in the current context of stagnating global demand (putting aside problems of global composition fallacy) – rathen than internal devaluation. Curious to hear other people’s thoughts on this.

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