Last summer, after two years of growing uncertainty, systemic risk in the eurozone finally began to wane, as conditional commitments came together. Italy and Spain offered credible fiscal and growth-oriented reforms, and the European Central Bank, with Germany’s backing, promised intervention as needed to stabilize the banking sector and sovereign-debt markets.=Unfortunately, that trend may be reversing. Growth in the eurozone has turned negative overall, significantly so in the south. Unemployment stands at about 12% in Italy, and 38% for the young. Likewise, Spain’s unemployment rate is above 25% (and 55% for young people). And French economic indicators are slipping quickly.
Meanwhile, the outcome of Italy’s election will most likely leave the country – the eurozone’s third-largest economy and the world’s third-largest sovereign-debt market – without a stable government. As a result, it will be difficult to sustain a reform program that is vigorous enough to satisfy the ECB and the eurozone core.
Surprisingly (to me, at least), markets have reacted stoically. Interest-rate spreads on Italian sovereign debt have widened, but not sharply. External investors may not be rushing for the exits, but they are not piling in, either. It feels like wait and see at this point.
Italy is the only debt-distressed eurozone country in which the negative competitiveness trends (productivity relative to income) have not reversed direction in the post-crisis period. With a debt/GDP ratio of more than 120%, Italy lacks the flexibility to implement fiscal stimulus to bridge the transition to higher growth.
Outgoing Prime Minister Mario Monti’s government accomplished a major pension reform, cut public spending, and raised taxes. But Italian voters overwhelmingly rejected his approach, in part because austerity did not appear to extend to elected officials or to major parts of the large ecosystem of departments, enterprises, and unions that surround government.
Systemic reform of Italy’s government may be a prerequisite to achieving consensus on a path to fiscal health and growth. But this is not the ideal moment for a timeout to do that. The real issues, in any case, are distributional and reflect a shortage of policy instruments.
For example, tax evasion is pervasive, so increases disproportionately hit those who already pay, fueling a widespread perception of unfairness. Monti attempted to address this, but moving from the current equilibrium to a better one, in which tax evasion is the exception rather than the norm, is a long-term project.
As a result, the burden of the crisis is being borne mainly by the unemployed and the young. Given Italy’s adverse competitiveness position, devaluation of the currency, were it possible, would not be a long-term substitute for productivity-boosting reforms, but it certainly would help in at least three ways.
First, devaluation would distribute the costs of rebalancing more evenly, making it easier to clear the burden-sharing hurdle to deeper reforms. Second, floating exchange rates imply that devaluation is an automatic adjustment mechanism, so it occurs without the appearance of an explicit burden-sharing choice and the accompanying potential for political gridlock.
Finally, as is true in many of the advanced countries, weak demand constrains Italy’s short- and medium-term growth. This means that, unless government spending provides the demand bridge, the large non-tradable part of the economy cannot drive growth and job creation. But Italy’s government, like that of the United States and other fiscally constrained countries, is subtracting effective demand.
Some parts of the global economy are growing. So a negative domestic demand shock need not completely constrain the roughly one-third of the Italian economy that is tradable – and thus could grow and generate employment if the competiveness parameters were reset quickly. Obviously, in the context of the eurozone, this is not an option.
The alternative is muted wage and income growth shared across the income spectrum, combined with productivity-enhancing measures. This was a component of Germany’s successful reform program of a decade ago, which included labor-market and social-security reforms, the combined effect of which was to restore competitiveness and growth potential in the tradable sector, while improving productivity on the non-tradable side.
This process does work in the long run. But Germany’s reforms took place in a much healthier global economy, and, when the initial divergences are large, it may take too long to restore growth.
Some observers have argued for a higher stable inflation target in the eurozone to facilitate the “relative deflation” process in countries that need it, and to put the “zero bound” on interest rates further away, thereby enhancing the potential impact of monetary policy. But inflation has its own adverse distributional and efficiency implications, and would be fiercely resisted.
It is hard to see how this ends well. The alternatives seem to be a lengthy and difficult return to growth and employment, or declining enthusiasm for the common currency.
Beyond that, the main lessons concern design flaws. In the eurozone, for the most part, national governments separately choose investment levels in infrastructure, education, research, and technology. Their labor-market, social-welfare, and competition policies vary. All affect the trajectories of growth, income, and employment.
So, even if the eurozone’s structure is modified to achieve the desired level of fiscal discipline and balance, in its current highly decentralized structure, countries will continue to diverge in other important respects. Divergence in policies and convergence in outcomes is not a realistic expectation. Adjustment mechanisms are needed, but external devaluation and inflation are not available, while labor mobility is partial at best.
Perhaps one could interpret the common currency as “forcing” eventual convergence in policies. But, realistically, loss of support for the euro might come first, precisely because the adjustment mechanisms are so limited.
No one doubts the depth of Europe’s official long-run commitment to integration. The huge design challenge is to find the right level of mandatory policy convergence – one that works economically and is acceptable politically.