Adjustment is the key to ending the eurozone crisis. The optimists are saying that this process of regaining competitiveness is now taking place. Look at the success of the Spanish export sector or the fall in Greek wages. And, in any case, the eurozone economy is rebounding, which helps further.
This judgment is profoundly wrong. It is true that the crisis countries have brought down their current account deficits. Italy and Spain are now running surpluses. Since Germany and the Netherlands have not brought down their current account surpluses, the eurozone as a whole has moved from an almost balanced current account in 2009 to a surplus this year of 2.3 per cent of gross domestic product, according to the International Monetary Fund’s most recent estimates. The IMF puts the 2014 current account surplus at 2.5 per cent. In other words, the eurozone is adjusting at the expense of the rest of the world.
But while the eurozone is a fixed-currency regime internally, it is nothing of the sort externally. The currency does exactly what textbooks say it should: it keeps on rising, thus offsetting the improvements in the current account. Last week the euro rose to more than $1.38 against the dollar.
You could put this rise down to the US budget crisis, or the Federal Reserve’s postponement of the tapering of its quantitative easing programme. And, sure enough, if the eurozone’s acute financial crisis were to return, the euro would no doubt fall again as investors pull out. But if things continue as they are, I would expect the currency to remain strong, possibly even to overshoot. An overshooting euro would take care of the eurozone’s current account surplus by raising the prices of its goods on global markets.
The rise in the exchange rate may persuade the European Central Bank to respond by cutting interest rates to negative levels and providing more liquidity to banks. This is generally a good thing. The main problem with the rise in the euro’s external value is that it makes the internal adjustment harder. The crisis countries need to lower their export prices but the higher value of the euro raises the prices of exports to outside the eurozone. (The exchange rate does not, of course, affects intra-eurozone trade.)
Judging the progress the eurozone has made on internal adjustments is hard as you must disentangle effects happening concurrently. You cannot arrive at a firm conclusion by just looking at the improvement in Spanish export performance, for example. The latest IMF World Economic Outlook included such an analysis, suggesting the internal adjustment was mostly cyclical, not structural. This is an important observation, buried in a subsection, itself hidden deep in the report. It essentially says internal adjustment is not really happening. The rise in the exchange rate ends the scenario whereby the eurozone pulls itself out of trouble by running large and persistent current account surpluses against the rest of the world.
The IMF notes that eurozone internal adjustment requires two types of price change in crisis countries. First, the prices of non-tradeable goods – a haircut in Madrid – will have to fall relative to those of tradeable goods such as a Seat car. Second, the prices of Spanish tradeable goods would have to fall against those of non-Spanish tradeable goods elsewhere in the eurozone.
Different countries had different adjustment paths and most managed a relative improvement in their competitiveness. But the IMF asks whether this will continue. Probably not. Adjustment was driven by the end of capital inflows. When cyclical conditions improve, which they will, current account deficits will return.
Not only that. The IMF reckons that reducing net external liabilities to levels that would be considered healthy elsewhere would need “much larger relative price adjustments than implied by the need to reverse past unit labour cost appreciation or to achieve current account surpluses”. Put bluntly: the scale of necessary adjustment is absolutely enormous. The IMF does not believe that this is going to happen. Its baseline 2018 forecast for Greece, Ireland, Portugal and Spain has the net foreign asset position – the gap between the assets they own abroad, and the assets foreigners own in their country – at less than minus 80 per cent of GDP. This is a level generally not considered sustainable.
Adjustment remains possible in theory, but a scenario in which the eurozone adjusts is inconsistent with stated policy. Germany’s new grand coalition will be fiscally less austere, but I see no see no scenario under which Berlin reduces its current account surpluses over the next four years. Reform fatigue has befallen the crisis states. Adjustment on the scale the IMF is talking about is just not going to happen, not even with stronger than expected growth.
In a monetary union adjustment is hard without any transfers and without a fiscal union. I know of no plausible plan how the eurozone can manage the dual feat of economic adjustment and debt sustainability within the straitjacket of official policy. And as long as such a plan does not exist, the crisis is not over.