Vic Duggan: Europe’s policy response to the ongoing sovereign debt and banking crises on the continent’s periphery appears to be in suspended animation. There is a conflict between short-term expediency and long-term strategy, as was clear from the most recent European Council summit.
Spain, Italy and those debtor countries locked out of the bond markets are pushing for a speedy resolution that brings their financing costs down to sustainable levels. Among their desired outcomes are a mutualization of sovereign debt at a Eurozone level and / or unlimited ECB bond purchases on the secondary market.
The German-led creditor bloc is understandably reticent. It is they who feel they will foot the bill, after all. Their concern is ‘moral hazard’: if they give in to debtors’ demands, they fear all impetus for discipline and reform will be lost. One way of putting it might be that they are as yet unwilling to buy the first round of drinks, in case others fail to do their duty.
What we are left with is a half-way house that falls between two stools: limited capacity for ESM purchases of sovereign bonds in return for ceded sovereignty and direct bank bailouts that break the bank-sovereign link in return for a banking union… some time in the future. Markets are not convinced, as evidenced by Spain’s still precipitous sovereign yields. By failing to sufficiently address this short-term challenge, the long-term strategy may well be undermined.
Meanwhile, Spain has been given more time to bring down its budget deficit while Greece labours under its current commitments. Cyprus has joined the ranks of the bailed out, and speculation mounts that others will follow.
Ultimately, this crisis is not so much about sovereign debt as about growth and competitiveness. Even a large sovereign debt is manageable – if painful – so long as the economy has the capacity to grow faster than the debt burden. Constrained in their ability to stimulate either public or private sector domestic demand, over-indebted countries seek export-led recovery.
With a dynamic, robust export sector, Ireland is better placed than most to achieve the holy grail of export-led recovery, even if domestic demand will lag far behind given the massive private sector debt overhang.
To date, the policy recommendation of choice for those who want to remain in or pegged to the euro has been ‘internal devaluation’. The Baltic countries are held up as exemplars of success. By dampening or forcing down nominal wages and prices, one can theoretically simulate a currency depreciation, make exports more competitive and grow your economy.
It has been argued that Ireland is an exporting laggard, that we should look to the recent Baltic experience for lessons on how to really get exports going: if only Ireland could accelerate austerity, they imply, we could bring back the boom. According to this logic, savaging public sector wages would both accelerate deficit reduction and drive down wages in the tradeable sector, thereby boosting export competitiveness. This is ‘internal devaluation max’. The 'Baltic Fallacy', and what it means for Ireland, is discussed in greater detail in this pamphlet I prepared for ICTU.
In fact, the only part of the Irish economy that has been growing in any meaningful sense is our record-breaking trade surplus. Ireland is no slouch on the export front, the sector proving remarkably resilient even in 2009 when global trade collapsed. Overall, our economy will only grow, however, if export growth is enough to offset the opposing contractionary forces of fiscal austerity and inconspicuous consumption.
If one examines the evolution of Irish Unit Labour Costs, one sees that not only did exports continue surging even as ULCs were increasing through the middle of the last decade, but since 2008, Ireland has seen a re-adjustment greater than our European neighbours, the Baltics included. Even on the current fiscal trajectory, Eurostat estimates that this trend is likely to continue in the years to come.
There are, moreover, some critical distinctions that render meaningless the comparison of Ireland with the Baltics. The Irish economy of today is neither comparable to the Irish economy of the late 1980s nor to the Baltic economies of today.
Estonia, the most developed of the Baltics, is today only half as wealthy as Ireland, measured by GDP per capita. Just as Irish living standards converged rapidly to, then surpassed, the European average in the 1990s, so one would expect the Baltics to now grow faster than Ireland, all else being equal. This is borne out by the OECD estimates of potential GDP growth, which is 2.5% higher in Estonia than in Ireland for both 2012 and 2013.
Incidentally, this is also the reason why Ireland will not again sustainably see the convergence rates of growth of the 1990s, and why bringing down our Debt-to-GDP ratio will be far more challenging this time around.
Even if the Baltics were not on a convergence path, they would still be expected to grow faster than their EU neighbours, simply because they were so badly hit by the financial crisis and pro-cyclical fiscal policy, far worse even than Ireland. Ireland, Lithuania, Estonia, and Latvia suffered peak-to-trough falls in GDP of 10.1%, 14.8%, 17.4% and 20.7% respectively.
The further they fall, the faster they climb because there is so much more slack in their economies, and because they have lost so much of their potential GDP. In part, the Baltics are making up for lost growth as they regain the convergence path.
Evidence from the Baltics demonstrates how the bulk of the burden of internal devaluation is forced on the labour market. Unemployment tripled across the board with non-tradable sectors, like construction, particularly badly hit. As the economy reorients towards tradable sectors, many of these jobs will not be coming back, and long-term structural unemployment is thus likely to remain elevated.
Nominal wages in the Baltics had fallen by 10-15% by early 2010. Public sector wages were slashed by as much as 30% in Latvia. In Lithuania, by comparison, more of the burden fell directly on private sector wages.
It is clear that internal devaluation has been hurting, but is it ‘working’?
Three years on, unemployment rates are still more than double pre-crisis rates across the Baltics, and emigration has reached epidemic proportions. While GDP is growing, it has yet to reach pre-crisis levels. Having fallen so far in 2008 and 2009, it is hardly surprising that there was a rebound effect in 2011. Growth is expected to slow to 2% across the region as this effect dissipates, and much of neighboring continental Europe remains mired in recession. Exports have recovered from the 2009 collapse in global trade, but are expected to slow significantly in 2012, even turning negative in Estonia.
Internal devaluation is no silver bullet, and may prove politically unsustainable if pursued over the long term. Indeed, it may prove to be socially, economically and financially unsustainable in the presence of a large public and private sector debt overhang, as in Ireland.
There is a school of thought that argues that beatings should continue until morale improves, that Ireland should up the dose of austerity just to be on the safe side. The truth is that economists are at a loss to predict the effect of ever-more more austerity when the output gap – a measure of how actual economic output compares to potential – is as wide as it is in Ireland today.
If one accepts the definition of insanity as doing the same thing over and over again, and expecting different results, then surely re-doubling belt-tightening austerity, and expecting growth, is economic lunacy?
We are dealing with known unknowns, and staying on the safe side probably means sticking to the IMF’s advice and not accelerating austerity. Our belt has no more holes, and tightening above and beyond what is absolutely necessary could turn a crash diet into a futile hunger strike.
Vic Duggan is currently working with the World Bank in Jakarta, having completed an MPA in Economic Policy Management at Columbia University. Vic has previously worked with the European Commission and the European Investment Fund, and served as an economic adviser to Joan Burton TD from 2008-2011. His blog can be read here.