The seeds of the European debt crisis were arguably sown when Greece, Portugal, Ireland and Spain, the afflicted peripheral eurozone members, adopted the common currency. And the solution might be to focus more intensely on boosting competitiveness through higher productivity gains, rather than merely relying only on austerity measures. These are the findings of a recent paper by the New York Federal Reserve.
To begin, before those peripheral members adopted the euro, they faced higher borrowing costs. This was due in part to inflation that was higher than that found in eurozone countries, and in part due to the potential for currency downgrades, which limited investors' appetite for these countries' debt. Investors also heeded credit risk of individual member countries to a greater extent before those countries adopted the common currency. The use of the euro enabled some countries to borrow more extensively abroad, as investors had less fear of inflation and currency devaluation. And only recently have investors become concerned with that heretofore-ignored risk of the potential for default.
That misperception of risk allowed a surge in foreign borrowing that was coupled with a fall in the savings rates of those countries. Those countries used the borrowed funds for consumption and for investments in housing, rather than investments in productive capital. This is important, because investments in productive capital can generate returns on capital to repay those loans to finance those projects, but consumption from borrowed money is very unlikely to spur any return on the use of those funds.
And consumption did increase as domestic savings fell. In Greece, for example, domestic savings as a percentage of GDP fell from about 18% in 1999 to just under 5% in 2010, while that in Portugal fell from 20% to just under 10% currently. Germany, by contrast, saw its savings rate increase from 20% of GDP in 1999 to about 23%.
In the classic story of the ant and the grasshopper, the view of the more frugal Germans toward their more profligate brethren -- who were able to finance that consumption only by piggybacking on Germany's aversion toward inflation to support a lower inflation rate and a more stable currency -- remains at the heart of attempts to resolve the issue today. As such, the measure most prescribed to resolve the budget deficits has been austerity, cutting the spending that led to the problems in the first place.
A Hard Choice
But it's more complicated than that. The adoption of the common currency meant that devaluation of the Greek, Portuguese and Irish currencies was no longer possible as a means to spur exports, since many of these countries' exports go to other eurozone countries. And since the current account (a broad measure of the trade balance) equals domestic saving minus domestic investment spending, one can increase the national savings rate by boosting exports as a means to repay the debt burdens. Exports depend, in part, on competitiveness of a nation in international trade.
Competitiveness, in turn, depends on unit labor costs (a function of wages and labor productivity) and the exchange rate. It can be enhanced by a combination of a falling exchange rate -- which is not possible for the peripheral members as long as they share a common currency, as many of their exports go to other eurozone members -- falling wages or rising productivity. Relying only on falling wages is not a desirable means to reach this end for obvious reasons, though it can be part of the solution.
That leaves improving productivity to reduce unit labor costs as a means of augmenting the competitiveness of the exports of the peripheral countries. Productivity might be enhanced by changes to the regulatory environment that reduce the frictions and distortions of the cost and use of capital and labor.
However, some of the means of boosting productivity can be unpopular with the public, as it is a function of output per unit of labor. If output cannot be increased, labor must be reduced -- and that means that some jobs could be lost or hours cut. That is, unless productivity is derived from innovation and business reorganization, which might juice output at the same time that labor inputs are constrained (but hopefully not reduced substantially). Thus, enhanced productivity equals better competitiveness, which means greater exports and more national savings to pay off debts.
Instead, the prescription has only been austerity -- simply cutting spending on consumption and investments, whether productive or not. This approach, while the simplest and perhaps most obvious, is perhaps not the most advantageous when it is the sole solution.
The New York Fed research cites a 2010 study done by the International Monetary Fund that determined that each percentage point in fiscal consolidation subtracts roughly 0.5 percentage points in GDP growth -- and that is when then exchange rate is flexible. Without a flexible exchange rate, the IMF determined that each percentage point in fiscal consolidation subtracts a full percentage point from GDP growth. Note that the peripheral nations have committed to reducing deficits of 6 to 9 percentage points of GDP from 2010 levels. Lower economic output equals less tax revenue to pay off those debts.
The encouraging takeaway is that competitiveness of Greece relative to other eurozone countries has improved in recent years, as well as that in Portugal and Spain to a lesser extent, in part because of productivity gains. Let's hope that policymakers will work on measures that can continue this trend rather than simply slashing spending.
Austerity alone might work against efforts to balance budgets, as the more the economies are weakened, the harder it will be to pay off those debts. A better measure is a more competitive economy with a more favorable trade balance, in addition to cutting spending (with an emphasis on reducing consumption and non-productive investments). Otherwise, the markets may believe that a long-term, favorable solution could be difficult to attain. However, it's easier said than done.