Eurogroup Must Shed Complacency
July 29th, 2008
Two aspects of the eurozone economy are often mixed up. One is its overall
performance. The other is the divergences that at any time exist within the
single currency area. The Spanish economy may be about to fall off a cliff.
But Spain accounts for only 11.8 per cent of the eurozone’s gross domestic
product. If you look at the eurozone from a great height, a meltdown of the
Spanish economy looks like a minor regional wildfire.
Overall, the eurozone economy is in reasonable shape. The latest indicators
point towards a slowing in economic growth but not a recession. The European
Central Bank is probably a touch too optimistic, as its own forecast has not
yet fully taken account of the seriousness of the US downturn. But there are
some reasons for guarded optimism. Most of the eurozone does not have a
house price problem. Corporate and personal balance sheets are in good shape
and credit to the private sector continues to grow at double-digit rates.
This does not usually happen when you are about to hit a deflationary slump.
But what about intra-eurozone divergences? I was struck the other day by a
statistic from the ECB that shows Spain losing competitiveness relative to
Germany, even now. We knew this happened during the years of high economic
growth in Spain and low growth in Germany. But the trend continued even when
the relative positions of the two countries were reversing. One explanation
is that Spanish wages are directly linked to inflation, while German real
wages are still declining.
Worse, Spain’s slippage comes amid the prospect of a serious downturn in its
economy. Last week’s collapse of Martinsa-Fadesa, a large property
developer, has been a reminder, if any were needed, of the massive scale of
the Spanish property crash. Serious financial and economic distress is
almost inevitable. Do not be fooled by the fact that Spanish banks had
virtually no exposure to US subprime mortgages. Being exposed to Spanish
mortgages is probably worse.
Spain is in a more delicate position than the US or the UK because, as a
member of a monetary union, the country has fewer macroeconomic adjustment
tools at its disposal. The dollar and the pound have devalued in real
effective terms, while Spain has one of the hardest currencies in the world.
Spanish interest rates have gone up while US rates have gone down.
The good news is that Spain has some room for manoeuvre in fiscal policy,
given its low debt-to-GDP ratio. But the whole structural and legal setup of
the eurozone requires that, in any adjustment, most of the heavy lifting is
done via the real economy. Spain is thus in danger of entering a decade of
misery, with falling real wages.
The problem is that even if Spain were to try to pull itself up through
competitive adjustment, it is not at all clear that this would work. I am
not even sure whether it works all that well for Germany in the long run,
but that is another story. Some degree of competitive adjustment is probably
needed but the huge scale of the shock that is unfolding in Spain will
almost certainly require a macroeconomic response that Spain cannot deliver
on its own.
Yet the eurozone’s system of economic governance is not designed to produce
this type of response. There are no cyclical transfer schemes, only
structural funds. No common rules exist on bank bail-outs. Small-minded
national banking regulators even refuse to countenance the very obvious
necessity of a central banking regulator for cross-border banks. The
eurozone does not even have single representation at the International
Monetary Fund. The economic shocks to be experienced by Spain, and by
Ireland, will seriously test the eurozone’s see-no-evil-hear-no-evil
approach to economic governance.
I have long thought that the only way the current set-up will be changed is
not through debate about future eventualities but as a result of being
plunged into crisis. Eurozone finance ministers – the so-called eurogroup –
are a complacent bunch. They never do anything until it is absolutely
necessary. But they will act eventually. I am relatively optimistic that
they will always be able to ward off the worst-case scenario, one that still
excites some commentators: the threat of a eurozone break-up.
So what actions would be needed? In the very short run, a transfer mechanism
to provide help for countries in severe distress. Of course, any transfers
would have to come with IMF-style conditions attached. As a price for an
increase in intra-eurozone solidarity, the other member states would almost
certainly demand that the beneficiaries end the silly policies that got them
into the mess in the first place. Spain, for example, should end the
automatic link between inflation and wages. It should also end the monopoly
of the one-month euro interbank offered rate mortgage, which has had a
hugely pro-cyclical effect on mortgage lending and the housing market.
The one institution that cannot help Spain is the ECB. Its role is to run an
optimal policy for the eurozone as a whole. Dealing with this hugely
asymmetric shock is primarily a matter for politicians, not central bankers.
Anybody who claims to be serious about economic policy co-ordination, such
as President Nicolas Sarkozy of France or the European parliament’s economic
and monetary affairs committee, should therefore stop bashing the ECB for a
few months and focus attention on the storm that is building up on the
eurozone’s western front.
Full story from FT.com
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