A Short, Cogent History Of The Eurozone: Why Peripheral Country Debt Is Toast

By Erico Tavares of Sinclair & Co.

Can market forces prevail in the Eurozone?

With another round of central bank intervention coming four plus years after the start of the Eurozone debt crisis, this is a question worth considering, at a time when the Southern Eurozone members - Italy, Spain, Greece and Portugal, which collectively account for over 30% of the GDP of the early adopters of the Euro as a whole – continue to struggle.

This is a complex topic for sure, but a simple economic indicator can be used to help frame the situation.

The Real Effective Exchange Rate, or “REER”, is a weighted average of a country's currency relative to an index or basket of other major currencies adjusted for the effects of inflation. A country with higher inflation will seek to devalue its currency to maintain competitiveness in relation to its trading partners (the reverse also applies of course, but these days nobody seems to want a strong currency). The REER therefore provides a gauge of that country’s competitiveness in foreign markets.

Under a fixed foreign exchange regime, policy options are much more limited. A Eurozone member can become much less competitive relative to another member with a lower inflation rate. Stated differently, its REER will increase in that situation. This dynamic provides an insight as to how the Southern European countries got into trouble in the first place, and some of the challenges associated with its resolution.

Historical Context Leading Up to the 2008 Financial Crisis

The oil shocks of the 1970s had very damaging effects in the southern contingent of the Eurozone, with inflation rates skyrocketing. Devaluations were therefore a necessity to regain competitiveness, although these also provided an inflationary feedback loop. In contrast Germany, and to a lesser degree France, more or less kept inflation under control during this turbulent period.

Figure 1: Historical CPI Inflation in Selected Eurozone Countries, 1965-2001

Source: www.inflation.eu.

It is important to understand this context, as these economies evolved out of a system that systematically used currency devaluation as a policy tool for many years.

In the 1980s, Portugal, Greece and Spain formally joined the European Community, having just transitioned to a democratic system in the prior decade. A program to promote economic convergence with the European “core” was then implemented. This included the establishment of trading bands with other European currencies in order to avoid wild swings and competitive devaluations between trading partners, as well as facilitate greater economic integration going forward.

As currency fluctuations narrowed, inflation at home would have to come down, otherwise the REER would increase as a reflection of higher prices for their goods and services abroad. Figure 2 shows this process of “convergence” in the Southern European countries from 1995 up until the last business cycle peak in 2007.

Figure 2: REER Yearly Index in Selected Eurozone Countries (1995 = 100), 1995-2007

Source: Eurostat.

(a) Based on the current 18 countries of the Eurozone.

Portugal’s “currency” (speaking figuratively) had appreciated in real terms by almost 15% over that period. Spain, Greece and Italy were not far behind. At the same time, the REER of their core Eurozone partners went in the other direction, declining by almost 10%, and thus gradually eroding the cost advantage and competitive edge of Southern Europe.

As shown in Figure 3, this loss of competitiveness had a very negative effect on the trade balance (goods and services exported minus imported) down south, with generally expanding deficits recorded over the period.

Figure 3: Trade Balance as % of GDP, 1995-2007

Source: Eurostat.

(a) Remaining founding members of the Euro combined.

Not even Italy, with its dynamic exporting sector in the northern part of the country, was able to buck the trend. On the other hand, the core countries as a whole were able to increase their trade balance throughout the period.

Figure 4 depicts the situation in absolute terms in 2007. Out of 188 countries in the world, our Southern European friends made the top 10 list ranked by current account deficits. Spain made it all the way to #2; Greece, at #6, had net imports of almost $4,000 per person, the highest by far in the ranking.

Figure 4: Top 10 Countries Ranked by Current Account Deficit in 2007 (US$ bn.)

Source: CIA World Factbook.

It should also be noted that China emerged as a trading powerhouse over this period. By 2007 it already boasted the world’s largest current account surplus. Southern Europe’s industries like textiles and light manufacturing, which historically had contributed significantly to their economies, were particularly vulnerable to Chinese imports. This was much less so in the core countries, which stood to gain disproportionately more from trading with Asia. So the composition of the export sector is also an important consideration.

If we rank the Southern European countries in accordance with their trade deficit as % of GDP in 2007, we get the same domino sequence of economies tumbling down during the 2010-11 Eurozone debt crisis: first Greece, then Portugal, followed by Spain, and narrowly missing Italy with the same virulence (Ireland is not shown here, but the crisis there was rooted in a different economic model).

For all the talk about government finances, turns out that trade deficits actually matter – even inside a fixed currency regime like the Euro. Years of heavy borrowing by the private and public sectors led to inflation in the form of relatively higher price levels and burgeoning trade deficits, further undermining the competitiveness of the economy at a time when the international markets were opening up.

At some point those imports become unsustainable and foreign lenders that provide the credit close the tap. And that’s precisely what followed.

After the 2008 Financial Crisis

Figure 5 shows how Southern Europe started to devalue in real terms as financial conditions deteriorated from 2008 onwards. The decline in REER is particularly pronounced in Greece, Spain and Portugal, spurred on by deep austerity measures and a big curtailment of credit to the private sector.

Figure 5: REER Yearly Index in Selected Eurozone Countries (1995 = 100), 2007-2013

Source: Eurostat.

(a) Based on the current 18 countries of the Eurozone.

And once again we see the trade deficits responding in tandem, as shown in Figure 6.

Figure 6: Trade Balance as % of GDP, 2007-2013

Source: Eurostat.

(a) Remaining founding members of the Euro combined.

The decline in trade deficits as % of GDP has been very substantial, after the large chronic deficits of “happier times” [Note: GDP accounting changed in all of these countries over this period to include things like illegal drugs and prostitution, which in some cases added 3% to the final calculation. Hmmm…]

Services Inflation

Under a fixed exchange rates regime, REER changes are fundamentally driven by differences in the inflation rate. We can break this down by: (i) goods inflation, which broadly reflects price changes in items that are easily traded across borders; and (ii) services inflation, for those which are not.

With open borders goods inflation should be fairly aligned across member states. As such, the key driver behind overall changes in competitiveness must be services inflation. This is shown in Figure 7 below.

Figure 7: Services Inflation by Eurozone Area, 1999-2014

Source: Eurostat, Clemente de Lucia (BNP Paribas).

Note: “Periphery” includes Greece, Spain, Portugal, Italy and Ireland; “Core” includes the Netherlands, Austria, Luxemburg, Belgium, Finland, Germany and France.

Going back to 1999, services inflation in the periphery was consistently higher than in the core up until 2009. This is very much in line with the relative performance of the REER over this period, as outlined previously.

However, with fixed exchange rates and open borders, what is driving this significant services inflation differential?

Figure 8: Relative GDP Performance vs Service Inflation Differential, 1998-2013

Source: Eurostat, Clemente de Lucia (BNP Paribas).

(a) Includes only the Eurozone founding members plus Greece.

(b) Difference between “Periphery” and “Core” services inflation rates in percentage points.

Figure 8 shows that faster GDP growth in the periphery was accompanied by relatively higher services inflation. With the onset of the Eurozone debt crisis in 2009, the trend reversed and the periphery started to grow much slower, as shown in the shaded area. Services inflation responded accordingly. This makes economic sense of course: under similar conditions, countries growing faster should experience higher price growth in non-tradable items.

Therefore, the lack of economic vitality in Southern Europe is adding significant deflationary pressure.

The Eurozone’s Unresolved Situation

Can the Southern European economies restructure their economies with the aid of a declining REER, that is, their goods and services becoming relatively cheaper abroad, and reverse the trend that has led to a steady accumulation of massive trade deficits over a decade and a half?

Recent experience suggests that this could be possible. However, sustaining that decline in the real value of the “currency” going forward will be very difficult for the following reasons:

  • Deflation improves competitiveness outright by reducing the cost base of the country (e.g. lower salaries). But this is very problematic for Southern European economies, as the already stratospheric debt levels continue to rise as the income needed to repay them goes down in nominal terms. Which is why the European Central Bank is so concerned with deflation.
  • The core Eurozone partners could conceivably endure relatively higher inflation to reduce their relative competitiveness, but this is also problematic: (i) as we have seen, this differential is largely driven by economic performance, meaning that Southern Europe could be failing to achieve the escape velocity needed to bring down debt ratios; (ii) the inflation rate differential needed to make a difference down south would likely to be too high for the core countries; and (iii) core countries compete against many other countries.
  • Greece has already seen a massive correction in its REER, which is now below the level in 1995. And yet the trade deficit remains stubbornly high compared to its closer peers. It is unclear by how much more prices would need to adjust to correct this. Sanctions against Russia, a major export market for them, could not have come at a worse time.
  • Politically, devaluation is not on the table. In any event, foreign debts resulting from a generational accumulation of trade deficits would explode in value overnight.

The inability of these countries to rebalance their foreign terms of trade highlights a major flaw of the Eurozone construct, which is largely based on conventional international economics thinking.

All the talk about free movement of labor, price adjustments and so forth breaks down once we realize the adverse implications that the required adjustments will have on debt ratios. It looks like we have hit one major economic SNAFU.

Figure 9: Eurozone Government Debt as % of GDP, 2013

Source: Eurostat.

(a) Remaining founding members of the Euro combined.

Figure 9 reminds us of how extreme the debt situation has become in Southern Europe, in this case just by looking at the public sector. In 2013, all the countries added together had a Government Debt as % of GDP ratio of 121.5%, much higher than their core Eurozone partners and more than double Maastricht Treaty levels. The ratio increased by a staggering 40 percentage points in just five years.

At these dizzying heights market forces just can’t be allowed to play out; and the debt situation in the southern Eurozone complex remains unresolved. Debt is the one thing that has steadily grown over the last four years in these countries.

Sure, we can all live in a world where central banks continue to keep interest rates at absurdly low levels (again, the market is not allowed to function) and paper over any sovereign blow-ups. However, the system becomes increasingly unstable. Moreover, the economic fundamentals continue to deteriorate as those countries struggle to regain competitiveness under a massive debt burden. And it is tackling that burden with non-conventional measures that eventually needs to be considered, but that’s a story for another time [Hint: that process starts with an “R”].

But OK, these are very pleasant countries to live in, with friendly people, great food and beautiful weather. For sure this can attract foreign companies and eventually develop such a productive economy that will mitigate any pricing disadvantages and help pay off the debts right?

And that would be excellent, except for the fact that these are pretty difficult countries to do business in. According to the latest “Doing Business Survey” by the World Bank, here’s how they ranked out of 31 OECD countries: Portugal (#19), Spain (#27), Italy (#29) and Greece (#30). Add the strong likelihood of higher taxes and pension costs to pay for all the debts as they come due and you might be better off just visiting.

If more goods and services don’t start leaving these countries more and more young people will, motivated by high unemployment at home and the prospect of a better life elsewhere. At least someone is working towards a real resolution.


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