Isn't Europe that old continent mired in an austerity-recession vicious cycle (now even expanding to core countries like the Netherlands)? There might be some life left in the old continent. It's always darkest just before dawn, as the saying goes.
For people who can look further than tomorrow, there is a new Europe being build on the ruins of (much of) the old. First, a note of caution. Although we have written dozens of articles about the subject, we don't know how the euro crisis is going to end. It could still be that the eurozone implodes. There are many banana peels on the road to recovery.
After the Greek 'haircut,' bond markets will be even more wary of eurozone debt from countries that might be next. Austerity might very well be self-defeating. Apart from very high debts, eurozone countries need to restore internal balance as the periphery has gotten way too expensive.
The table above rather understates the imbalances as productivity growth was higher in Germany in the last decade, compounding the price level differentials. So the picture below gives a better idea:
To solve these problems, these countries find themselves faced with a bit of a catch-22 situation. The 'internal devaluation' route (slashing domestic wages and prices) to restoring competitiveness is deflationary and increases the real debt burden. However, reflation to boost growth and tax receipts would not address the competitiveness gap. The result is a rather awkward policy choice.
The troika (EU, ECB, IMF) has prescribed deflation and austerity on countries that don't have access to the debt markets (Ireland, Portugal, Greece).
We think the balance has been somewhat wrong as austerity in times of economic crisis has a tendency to worsen the crisis and risk a downward spiral. This has obviously been the case in Greece, where the debt/GDP ratio has only increased further while the economy slumps. The same danger looms in other eurozone countries like Portugal, Spain and Italy.
But one has to make a choice, and a rather awkward one. Is there a way to soften this awkward trade-off? Well yes, as it happens, and here is where the good news lies.
Creative destruction in Europe
We always argued the emphasis should be on more structural reforms, and less austerity (at least during periods of low or even negative growth, as austerity will lower economic growth even further). Structural reform is not a panacea, or likely to deliver instant gratification. However, over time it will deliver more dynamic, entrepreneurial and resilient economies. It also increases competitiveness, and that's a crucial ingredient for the eurozone periphery.
The combined effects of austerity and the economic crisis is that a lot of productive capacity is being wiped out. If capitalism is creative destruction, as Schumpeter had it, then this is definitely a time of considerable destruction. In textbook economics, this is actually a good thing-- believe it or not. It's like cutting out dead wood and making room for new growth. Resources will be magically transformed and put to use in new places where they're more productive. However, in the real world, there are a couple of things to consider:
- The periphery has lost competitiveness within the eurozone for years, export capacity disappeared for some considerable time
- In the real world, resources are not infinitely malleable and can't be put to new, more productive uses with any type of speed
- This holds true especially for labor, when people become unemployed for a long time, their skills become rusty and less marketable, they tend to become discouraged, and they're discriminated against in the labor market
- Important knowledge and production routines are lost when companies fold and are difficult to recreate or reassemble
So a lot of production capacity and knowledge gets wiped out. However, this tends to be the least productive capacity, and the way is opened to start anew when the economy has stabilized.
It is often argued that embarking on structural reform might only add to the misery in the short-term. However, the costs of these reforms as such should not be overstated, according to the OECD:
Concerns that reforms may entail short-term economic losses before their benefits start to materialize seem to be overdone. New empirical evidence provided in Chapter 4 suggests that some structural reforms may fairly quickly boost growth while very few if any have short-term costs in general.
The Organization of Economic Cooperation and Development (OECD) recommends and keeps track of structural reforms since 2005 for its member countries. The good news is that the uptake of these reforms seems to have sped up lately, especially in the eurozone periphery.
This isn't a terrible surprise as many of these countries have their back against the wall. After a lag, the crisis has acted as a catalyst for structural reform and (according to the OECD):
...there is a strong cross-country correlation between the intensity of ongoing fiscal consolidation efforts and responsiveness to Going for Growth priorities over the period 2010-11.
What is structural reform?
Here, again, is the OECD:
Structural reforms recommended in Going for Growth are aimed at improving living standards by raising either labor productivity, or labor utilization or both. Labor resource utilization is measured as the total number of hours worked per capita, while labor productivity is measured as GDP per hour worked.
Well, these are simply measures aimed at improving the supply side (rather than using the normal tools of demand management like fiscal and monetary policy). One should think of things like:
- Improving education systems
- Making it easier to start new businesses
- Tax reforms and improved tax collection
- Increasing labor utilization (strengthen incentives to retire later, increase labor force participation, etc.)
- Active labor market policies (retraining, temporary work schemes and the like)
- Improving innovation systems (forging links between universities and business, financing basic research, information exchange etc.)
- Increasing product market competitiveness (especially in retail and personal services there is a large potential to create more jobs though increased competition)
- Improving the functioning of labor markets (reduce protection of professions, loosen job protection etc.)
- Public sector reforms
You'll see in the graph above that the uptake of these kind of structural reforms in Greece has been the most impressive, even if, at times, there is a bit of a gap between laws made by the Greek parliament and reality on the ground. One can read more about the progress in Greece in the OECD country notes.
It doesn't look like the report has taken Mario Monti on board, the technocrat Italian premier who took over from Silvio Berlusconi. In the couple of months he has been in power he has already achieved more than Berlusconi did in more than a decade, shaking up the Italian economy and restoring confidence of the financial markets in Italy's debt.
There has been a veritable supply-side revolution in Italy since Monti took over. Bumping against many vested interests hasn't slowed him down, introducing many unpopular measures like a 35 billion euro in austerity package, increasing the pension age and all kinds of market liberalizing measures. All that hasn't diminished his personal popularity much, which continues to be extraordinarily high (55-70%).
His personal no-nonsense style and hard work (just sleeping 4 hours a night, taking the train home to Milan and refusing a salary, for instance) has no doubt contributed to that as well. Italy, meanwhile, has been brought back from the brink. Bond yields have fallen back from above 7% to below 5% (on 10 year bonds), basically to where they were before Italy got sucked into the euro crisis last year.
Click to enlarge
The jury is still out whether these rather heroic efforts are enough. Italy's economy is expected to shrink substantially and the country's competitiveness can't be restored overnight. But Monti is the best that could have been hoped for just a few months ago.
Structural reforms are implemented all over Europe, especially in those countries that have their back against the wall, like Greece, Portugal, Italy and Spain. Not only does this soften the trade-off between reflation and deflation (the Catch-22 situation discussed above), but this builds the foundation for a much more competitive Europe when it finally emerges from the eurozone crisis.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.