In the beginning, the eurozone crisis featured two core problems: large imbalances of trade and competitiveness, and a daunting debt mountain. Two years on, the challenge has shifted: there have been striking advances in competitiveness but the debt is as formidable as ever. This metamorphosis suggests two lessons. First, the morality tale version of the crisis, which blames profligate Mediterraneans, has ceased to be relevant. Second, it is time to modify the argument that the countries of the periphery are doomed because they lack flexible national currencies. Their really crippling disadvantage is that they lack flexible national central banks.
Consider Spain's predicament. For 10 years after the launch of the euro, its workers bid up wages: labour costs jumped 55 per cent compared with a rise of 22 per cent in Germany. Outsized wage gains were not offset by gains in productivity, which lagged behind Germany's by a whisker. The upshot was that uncompetitive Spain ran a vast current account deficit, peaking in 2007 and 2008 at about 10 per cent of gross domestic product – a gap that dwarfed the infamous external deficit run by the US.
When the crisis began in 2010, the question was whether Spain could correct that deficit, given an inflexible exchange rate. Of course, flexibility would have helped. But in 2011 and early 2012, Spain's wages fell relative to Germany's and its productivity gains were larger; the supposedly indulgent Spanish private sector has achieved a fall in unit labour costs versus Germany of 8.7 per cent. Thanks to renewed competitiveness, Spain's exports rose 7.6 per cent last year and will rise another 2.1 per cent this year, despite recession in Spain's export markets. Add in the cyclical effect of falling imports and the country's external deficit has fallen remarkably, from 10 per cent of GDP to this year's forecast 2.4 per cent.
Now consider what has happened to Spain's debt challenge. As they bid up wages too much, Spaniards also borrowed excessively: between 2000 and 2010, debt held by Spain's non-financial companies and households doubled to a whopping 214 per cent of GDP. When the credit bubble burst, tax revenue fell and lenders required bailouts, pushing government debt up. Together, public and private debt posed a question analogous to the one raised by the current account: could Spain adjust?
Here, unfortunately, the answer is less positive. Since 2010, private debt to GDP has come down only slightly, to 204 per cent. Gross government debt has meanwhile exploded, from 61 per cent of GDP in 2010 to 90 per cent in 2012, according to the International Monetary Fund. Putting a brave face on things, the IMF projected last year that Spain's government debt to GDP ratio would be 76 per cent in 2016. When it redid its projection recently, its 2016 forecast had leapt to 97 per cent.
Why is Spain failing to cut debt? It is not for lack of grit. The big reversal has taken place in the public sector, yet the savings effort there has been respectable: the IMF estimates that Spain's cyclically adjusted budget deficit has come down from 9.7 per cent in 2009 to 4.6 per cent this year. The private sector is saving 10.7 per cent of disposable income, less than thrifty Germans but considerably more than Britons or Americans. Spain is discovering that belt-tightening can be futile in the absence of aggressive action from the central bank.
Consider the contrast with the US and Britain, countries that also experienced credit bubbles. There, national central banks embarked on quantitative easing, pushing down interest rates even as they pushed up growth and inflation. This transformed the arithmetic of debt reduction. With nominal interest rates below nominal growth rates, the debt stock grows more slowly than output, driving down the ratio of debt to GDP. Of course, fresh borrowing can still pull the ratio upwards. But quantitative easing creates a kind of moving carpet, allowing the passenger to walk backwards and yet advance.
Spain is also on a moving carpet, but it is travelling the wrong way, fast. Nominal growth is negative and the government's 10-year borrowing rate in October was 5.7 per cent, with private rates higher. This differential is ruinous. Even if Spain ceased borrowing, debt would grow faster than output, exacerbating doubts about Spain's solvency and pushing interest rates further up.
To be fair to the European Central Bank, it has tried to be helpful. Spain urgently needs to swallow its pride and accept external monitoring of its economy, freeing the ECB to lower borrowing costs by purchasing short-term Spanish bonds. But even if the ECB activates its promised outright monetary transactions, Spain's interest rates will still be above the growth rate. The stated goal of these transactions is to eliminate the penalty Spain pays because of fears of exit from the euro. It is not full-blown quantitative easing on the US or British model.
Perhaps the ECB will be more aggressive than it has indicated. Or perhaps a strong US recovery will pull the world out of recession, allowing Spain to escape its debt via export-led growth. But the positive surprise would have to be huge to change Spain's dynamics, which suggests the country is likely to need debt restructuring in the end. If that is right, Europe should act urgently. One in four Spanish workers is jobless. A bolder set of leaders would tackle Spain's debt now.
The writer is a senior fellow at the Council on Foreign Relations and an FT contributing editor
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