SERIOUS MONEY:If single currency is to continue, current account imbalances must be addressed in a co-ordinated way, writes CHARLIE FELL
THE APPETITE for risk has returned to financial markets and investors appear to have concluded that the potentially lethal “Greek flu” is not so contagious after all.
A Greek tragedy has been avoided for now, as pledges of support for the troubled member state from euro zone ministers have soothed investors’ nerves to some extent.
It would be incorrect to conclude, however, that the solution to Greece’s travails rests entirely with the Greeks. The reality is broader in scope and stems from the considerable intraregional imbalances that are fuelling macroeconomic tensions and threaten to tear the single currency project apart.
Close inspection of the underlying economic trends since the launch of the euro more than a decade ago give cause for concern.
The external position of the euro zone has been more or less balanced over the past decade, but that overall picture conceals considerable growth in current account imbalances among the countries participating in the Economic and Monetary Union (EMU).
Spain, Greece, and Portugal occupy one end of the spectrum. They began EMU with already high current account deficits of 3, 4 and 8 per cent of GDP respectively – having previously run current account positions close to zero in the mid-1990s.
The current account positions of all three countries continued to deteriorate under EMU, and reached levels unprecedented among euro-zone countries, with the exception of Portugal in the 1970s and Ireland in the mid-1980s.
Spain’s current account deficit soared to 10 per cent of GDP in 2007, Greece’s deficit approached 15 per cent in the same year and Portugal’s deficit remained in single digits by a whisker.
Germany, which occupies the other end of the spectrum, recorded small current account deficits averaging about 1 per cent of GDP during most of the 1990s and started EMU with a modest deficit; it did not move into surplus until 2002. The current account surplus continued to increase in subsequent years and reached a cyclical peak at almost 8 per cent of GDP in 2007, with roughly half the surplus generated through trade with the economies of the currency union.
The current account imbalances reveal that the competitiveness between various members of the euro zone has diverged steadily and significantly since the creation of European Monetary Union, and that this potentially destabilising trend began in the mid-1990s.
Germany adopted a wage deflation strategy in response to the strong increase in unit labour costs that followed reunification. This process was largely complete when EMU began in 1999, yet the wage restraint persisted through the decade that followed, with the annual average nominal unit labour cost growth at zero compared to 2 ½ per cent or more in some other member states.
There is little if any evidence, however, that the deutschmark was overvalued in the late 1990s.
Indeed, it should be recalled that Germany recorded a trade surplus equivalent to 3.3 per cent of GDP in 1999 and net exports made a positive contribution to economic growth from 1995 to 1999.
Not surprisingly, some have accused the Germans of pursuing “beggar thy neighbour” policies, akin to the competitive devaluations that proved so destructive during the 1930s. Instead of currency devaluation, Germany is said to be using wage deflation to capture export share from its trading partners. Ironically, EMU was supposed to prevent such “beggar thy neighbour” policies.
Wage restraint boosted the competitiveness of German exports, but its counterpart has been relatively weak domestic demand.
Compensation per employee has increased by just 7 per cent since 2001, substantially below the 34 per cent rise observed in the rest of the euro zone. The lack of consumer firepower has resulted in a less than 2 per cent cumulative gain in consumer spending since 2001.
Thus, Germany has not only captured export share but has deprived other euro-zone members of support from one of their most important trading partners.
Furthermore, the stagnation in German domestic demand caused interest rates to be lower across the euro zone than would have been warranted otherwise. The low real interest rates among the periphery not only precipitated a credit-fuelled consumer boom, but also an unsustainable bubble in asset prices that has since turned sour. The adverse impact on potential economic growth rates will be long lasting.
The counterpart to the continual current account deficits run by Spain, Greece and Portugal is a rapid deterioration in each country’s net international investment position and, combined with unsustainable fiscal deficits that require immediate attention, it is far too premature to declare that a sovereign debt crisis has been avoided.
Painful adjustments need to be made, but the political will may well be lacking.
The current outlook can only be described as fragile. Leadership is required and since Germany was part of the problem, it must therefore be part of a co-ordinated solution; otherwise the single currency project may fail. Investors would do well to remember that pigs can’t fly.
