Portugal, Greece, Spain Stand No Chance on Their Own

Jan.18.11 | About: iShares MSCI (EWP)

By Rebecca Wilder

This week Trichet laid down the ECB's hand, (effectively) announcing his intention to maintain inflation at the ECB's target rather than allow it to overshoot. For all intents and purposes, 2% inflation stabilizes the real exchange rate rather than furthering real depreciation in the Periphery and real appreciation in Germany (or the Core).

Ambrose Evans-Pritchard agrees with my interpretations of Trichet's speech:

Mr Trichet’s fire-breathing rhetoric can be taken as a signal that the ECB will continue to run monetary policy for German needs and tastes, refusing to accommodate a little slippage on inflation to let Club Med regain lost competitiveness without having to endure the agony of debt-deflation. Indeed, the ECB seems to have picked up some of the worst habits of its mentor.

Only the rebalancing of inter-euro current accounts will bring stable fiscal finances for debtor and creditor countries alike, something made more difficult with 2% average inflation! Trichet, in an interview with German newspaper, Bild.de, doesn't acknowledge this fact (bolded by RW):

Let me be very clear: this is not a crisis of the euro. Rather, what we have is a crisis related to the public finances of a number of euro area countries. All governments have to put their finances in order, and above all those governments and countries which have lived well beyond their means in the past.

Really? On the aggregate, Euro zone economies 'living well beyond their means' are now doing so in two respects: the current account deficit and public deficits. They're not the same. Don't even start with the 'twin deficit' story - Rob Parenteau refuted that some time ago.

It's not about government dissaving, per se. For countries like Spain, or any other Euro area economy with years of accumulated private sector leverage, the only way for the public sector to simultaneously reduce fiscal and private deficits is for foreigners to dissave (foreigners run large CA deficits). (See a previous post of the 3-sector financial balances model here.)

Given the close trade ties in the Euro zone, growing income from abroad effectively means a transfer of saving from the Eurozone Core to the Periphery via the current. This requires real appreciation in Germany, for example, and real depreciation in Spain.

First, real appreciation/depreciation could have been given a fighting chance with a lapse of the inflation target. Trichet made it quite clear where the ECB stands on this front: NEIN.

Portugal, Greece, and Spain have essentially no chance if left to their own accord.

Spain along with other Periphery economies are relatively "closed" compared to the German export powerhouse; that needs to change.

Click charts to enlarge

The chart above illustrates the degree of openness across the Eurozone, as measured by (exports + imports) divided by GDP. Spain, Greece, Italy, and France (expected to run budget deficits the size of Spain this year) are the most 'closed' of the Euro area (16, not including Estonia). In Greece, Spain, and Italy, the GDP share of export income has decreased over the last decade; furthermore, it's imports, rather than exports, that make the larger contribution to economic openness.

Export share
(Q3 2010)
Import share
(Q3 2010)
Greece 20.2 26
Spain 26.1 27.5
Italy 27.0 28.5
Click to enlarge

Even if Spain was more 'open', real appreciation is ingrained in the economy, as represented by unit labor costs. Structural reform is required on many fronts, private and public.
Since 2001, Spanish unit labor nearly doubled, +46%, while those in Germany grew just 17%. Recently, unit labor costs in Spain have stabilized. This is due to the contraction of the construction sector, which dragged productivity in recent years. Going forward, more is needed.

The EU made several recommendations in their 2010 Surveillance of Intra-Euro-Area Competitiveness and Imbalances (pg. 78):

Enhancing productivity in a more sustainable way would involve further investment in and enhancing the efficiency of expenditure in research, development and innovation, as well as improving the efficiency of R&D expenditure are crucial for achieving productivity advances. Further improvements of the education and life-long learning systems and investment in human capital should also be envisaged. This may be achieved inter alia, by ensuring the effective, implementation of widespread education reforms in addition to upgrading the skills and increasing mobility of the labour force to promote a swift transition into employment, and reducing segmentation in the labour market.

Nowhere does the report say that competitiveness should be achieved by getting public finances 'in order'. In fact, I'd deduce from these comments that more, rather than less, government spending is needed.

Without > 2% inflation, these countries don't stand a chance.

Appendix: Another measure of relative price competitiveness, the GDP deflator.