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 theEuropean Central Bank, with Germany’s backing, promised intervention as neededto stabilize the banking sector and sovereign-debt markets.
Unfortunately, that trend may be reversing. Growth in theeurozone has turned negative overall, significantly so in the south.Unemployment stands at about 12% in Italy, and 38% for the young. Likewise, Spain’sunemployment rate is above 25% (and 55% for young people). And French economicindicators are slipping quickly.
Meanwhile, the outcome of Italy’s election will most likelyleave the country – the eurozone’s third-largest economy and the world’sthird-largest sovereign-debt market – without a stable government. As a result,it will be difficult to sustain a reform program that is vigorous enough tosatisfy the ECB and the eurozone core.
Surprisingly (to me, at least), markets have reactedstoically. Interest-rate spreads on Italian sovereign debt havewidened, 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 whichthe negative competitiveness trends (productivity relative to income) have notreversed direction in the post-crisis period. With a debt/GDP ratio of more than 120%, Italy lacks theflexibility to implement fiscal stimulus to bridge the transition to highergrowth.
Outgoing Prime Minister Mario Monti’s governmentaccomplished a major pension reform, cut public spending, and raised taxes. ButItalian voters overwhelmingly rejected his approach, in part because austeritydid not appear to extend to elected officials or to major parts of the largeecosystem of departments, enterprises, and unions that surround government.
Systemic reform of Italy’s government may be a prerequisite to achievingconsensus on a path to fiscal health and growth. But this is not the idealmoment for a timeoutto do that. The real issues, in any case, are distributional and reflect ashortage of policy instruments.
For example, tax evasion is pervasive, so increasesdisproportionately hit those who already pay, fueling a widespread perceptionof unfairness. Monti attempted to address this, but moving from the currentequilibrium to a better one, in which tax evasion is the exception rather thanthe norm, is a long-term project.
As a result, the burden of the crisis is being borne mainlyby the unemployed and the young. Given Italy’s adverse competitivenessposition, devaluation of the currency, were it possible, would not be along-term substitute for productivity-boosting reforms, but it certainly wouldhelp in at least three ways.
First, devaluation would distribute the costs ofrebalancing more evenly, making it easier to clear the burden-sharing hurdle todeeper reforms. Second, floating exchange rates imply that devaluation is anautomatic adjustment mechanism, so it occurs without the appearance of an explicitburden-sharing choice and the accompanying potential for political gridlock.
Finally, as is true in many of the advanced countries, weakdemand constrains Italy’s short- and medium-term growth. This means that, unlessgovernment spending provides the demand bridge, the large non-tradable part ofthe economy cannot drive growth and job creation. But Italy’s government, likethat of the United States and other fiscally constrained countries, is subtracting effectivedemand.
Some parts of the global economy are growing. So a negativedomestic demand shock need not completely constrain the roughly one-third ofthe Italian economy that is tradable – and thus could grow and generateemployment if the competiveness parameters were reset quickly. Obviously, in the context of the eurozone, thisis not an option.
The alternative is muted wage and income growth shared across theincome spectrum, combined with productivity-enhancing measures. This was acomponent of Germany’s successful reform program of a decade ago, whichincluded labor-market and social-security reforms, the combined effect of whichwas 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’sreforms took place in a much healthier global economy, and, when the initial divergences are large, itmay take too long to restore growth.
Some observers have argued for a higher stable inflationtarget in the eurozone to facilitate the “relative deflation” process incountries that need it, and to put the “zero bound” on interest rates furtheraway, thereby enhancing the potential impact of monetary policy. But inflationhas its own adverse distributional and efficiency implications, and would befiercely resisted.
It is hard to see how this ends well. The alternatives seemto be a lengthy and difficult return to growth and employment, or decliningenthusiasm for the common currency.
Beyond that, the main lessons concern design flaws. In theeurozone, for the most part, national governments separately choose investmentlevels in infrastructure, education, research, and technology. Theirlabor-market, social-welfare, and competition policies vary. All affect thetrajectories of growth, income, and employment.
So, even if the eurozone’s structure is modified to achievethe desired level of fiscal discipline and balance, in its current highlydecentralized structure, countries will continue to diverge in other importantrespects. Divergence in policies and convergence in outcomes is not a realisticexpectation. Adjustment mechanisms are needed, but external devaluation andinflation 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 theeuro might come first, precisely because the adjustment mechanisms are solimited.
No one doubts the depth of Europe’s official long-runcommitment to integration. The huge design challenge is to find the right levelof mandatory policy convergence – one that works economically and is acceptablepolitically.