As Eurozone countries share the same currency, external devaluation is not an available tool to restore their competitiveness. The only way to achieve higher competitiveness is through internal devaluation. The rationale behind austerity programs is thus to reduce the labour cost of under-competitive countries in order to decrease prices and stimulate their exports. In the same line, countries are required to decrease public spending and increase fiscal revenues in order to have healthier public finances.
However, austerity also has very negative consequences. It hampers consumption and investment, lowering growth - according to an IMF study in 2012, the Keynesian multiplier (i.e. loss of growth resulting from 1% fiscal contraction) ranged between 0.9 and 1.7-. Consequently, the debt to GDP ratio increases and the public debt becomes even less sustainable. Fearing a default, investors sell government bonds, in turn increasing interest rates. As borrowing becomes more expensive the debt rises, requiring more austerity… A vicious circle becomes easily identifiable, known as austerity trap.
Although high public debt and lack of competitiveness are structural problems of the European Monetary Union, they are not at the heart of the crisis. The Eurozone crisis is first and foremost the consequence of a private credit-led boom resulting from financial innovation, such as subprime credit, and the accession to the euro for previously weak currency countries, such as Greece, Portugal or Spain, that allowed them to borrow at low interest rate thus fuelling a bubble. Consequently, the increase of sovereign debt is the outcome of the attempt of governments to save their banking system by massively buying private debt.
Germany is often cited as an example of strong economy, with sound public finances and competitive exports, resulting from a successful austerity policy. The German economy was far less impressive at the beginning of the 2000s, and the country was the so-called “sick man of Europe”. Important (and unpopular) reforms were implemented, freezing wages until 2007. This gave to the country a competitive advantage in terms of exports, compared to its European partners. However, it is important to recall the economic environment at that time: the rest of the Eurozone, and of the world, were in an economic boom period. If Germany performed so well in term of exports, it is because it benefited from a dynamic of demand in the rest of the Eurozone and of the world that created space for German exports. This dynamic-demand environment does no longer exist in the Eurozone, and has decreased in the other parts of the world since the subprime mortgage crisis in 2008.
If “debtor countries” want to implement successful austerity policies, “creditor countries” must implement stimulus policies in order to create demand and space for exports. However, creditor countries are not willing to implement stimulus policies and to risk losing their competitive advantage…
Moreover, “one size does not fit all”. All Eurozone economies’ structures are different. While some economies are very open and have a model based on exports, others are relatively close and rely more on their domestic consumption. This explains why the reduction of labour cost in Ireland has been successful while the opposite holds in Greece. The former has a very open economy, while the latter has a rather close one. One of the consequences of austerity in Greece has thus been to reduce domestic consumption and investment, without notable increase in exports.
Reducing debt and increasing competitiveness requires time and must be implemented in the medium and long run. According to a study from Goldman Sachs, the internal devaluation (i.e. labour cost diminution) required in Spain, Greece and Portugal to restore their competitiveness ranges from 25 to 35%. In France, the estimation ranges from 15 to 25% and in Italy from 5 to 15%. Requiring intensive austerity programs on a short time period is socially very costly and counter-productive. This is exacerbated by the rise of extreme and anti-austerity political parties such as Syriza and Golden Dawn in Greece, the Front National in France, Podemos in Spain or Movimento Cinque Stelle in Italy. Therefore, a different “timing” for austerity is needed. European policy makers should first implement stimulus policies in order to have growth recovery in the short run, and then implement austerity policies in the medium run to decrease budget deficit and increase competitiveness. In the other way around, austerity can lead to an “austerity trap”, making growth recovery impossible. As such, it seems that the economic debate around the Euro crisis has more to do with politics than economics…
*The views expressed in this article are of the author and do not represent those of The Political Analysis.