There are several factors that explain the current Eurozone crisis. One of them – arguably the key factor – is the sharp difference between economies inside the Eurozone and the different developments they had in the years leading up to the crisis. A currency is a tool to price a country’s factor markets and in the medium-to-long term a currency reflects how productivity and competitiveness of a country evolves. The problem for a currency union is if there are big differences how countries inside that union evolve. And big, big, big differences there have been between euro countries.
The table below shows the difference in unit labour costs between two groups of countries. Austria, Finland and Germany showed muted growth in unit labour costs after the dot-com crisis up to the financial crisis. Germany had four consecutive years of negative ULC growth, which means that productivity grew faster than salaries. In other words, the labour cost for producing one unit of output shrunk. Greece, Italy, Portugaland Spain, however, had consistently faster rise in unit labour costs, meaning that the labour costs for producing a unit of output increased. Indeed, the overall trend for these countries is that ULC grew remarkably fast. Greece’s unit labour costs averaged at 3.6 percent for the six years in the table below. Italy scored an average at a little more than 2.7 percent.
So the total unit labour costs in Greece increased by almost 24 percent in these six years. In Italy it grew by 17 percent. Germany, which represents almost 30 percent of the GDP in the euro area, had a completely different development. It’s aggregated unit labour costs declined by more than 3 percent in those years. Austria and Finland did not experience falling unit labour costs, but growth there was moderate.
Inevitably, the difference between these countries was going cause huge frictions inside the Eurozone. With Germany representing such a big part of GDP, countries that could not follow Germany’s trend would experience a mis-pricing of their labour market, leading to strong downward pressures on export growth and economic growth. Notably, the countries that deviated mostly from Germany in their unit labour costs are now the countries in biggest troubles.
One indicator of the problem is the current account development in the years leading up to the crisis. I am not a fundamentalist when it comes to current account balance; I think there are several other factors than productivity and labour costs that define a country’s current account and determine its capacity to have long-run surpluses or deficits without causing other structural problems. Yet it is different for countries insidea currency union – and in the case of Greece, Italy, Portugal and Spain there is an obvious link between their ULC performance and current account record. As the table above shows, countries with muted growth in unit labour costs had current account surpluses while the PIGS countries expanded their deficits – and quite sharply so.
One of the adjustments in the past years is that private funding of deficits has no longer been available to the extent as before the crisis. Consequently, private credit in PIGS countries has contracted but at the same time public lending from abroad has increased, affecting the balance of payments. Credit contraction will continue and foreign inflows of money will decline. This is a tough, but necessary, adjustment. It could have been managed much better, but at some point it has to happen.
A problem, though, is that these countries do not get any help from a decline in their unit labour costs. Given the mis-pricing of their labour markets, it is a significant adjustment that has to happen to rebalance their economies. But it does not seem to be taking place – at least not to the degree it should if countries should be able to remain inside the Eurozone without long-term, constant downward pressures on export and economic growth. The table below shows the quarterly development of unit labour costs in selected economies (data missing for Greece). Spain has seen a decline in ULC in this period, which is reason for optimism as far as Spain is concerned. Portugal has in the past years had an almost flat development. Italy, however, has seen a rise in its unit labour costs.
This is worrying.
It means that traditional and non-traditional central bank tools are not so efficient as adjustment mechanisms as they should.
It also means that it will be difficult to return to trend growth, let alone growth above the trend, which is necessary for especially a country like Italy with a public debt that will have to come down considerably in the next decade.
Continued mis-pricing of factor markets will have downward pressures on export growth at a time when such growth is more important than ever. PIGS countries can not rely on domestic consumption as a factor of growth. Consumption will in fact decline as austerity measures kick in and as current account stabilisation continues.
If countries like Italy cannot reverse the trend of its unit labour costs – by increasing labour productivity – it will have several decades of recession ahead of it. Or it will have to step out of the Eurozone and fix its problem through depreciation.
The problem for the Eurozone is this: To address the current crisis, it will have to either mutualise debt or allow the ECB to take on another role, centred upon forceful temporary actions to bring down bond yields. But Germany and other countries, plus the ECB, will not do that because they believe such actions will just take the heat off PIGS countries that must reform fiscal and economic policy much more than they have done so far. Yet the pressures on PIGS countries – or conditions attached to bailout programs – are almost entirely focused at budget balance. And austerity measures without depreciation of exchange rates (nominal, or real through labour costs) and structural economic reforms will not balance these economies. On the contrary, it is much more likely to drive down economies further.