While helpful in buying time, the ECB will be left addressing only the symptoms (illiquidity, volatility). Solving the underlying problems – insolvency and disparate competitiveness – could take years.
To highlight this, we map progress by uising the OECD’s latest estimates to 2012 of a country’s manufacturing unit labour costs relative to its main trading partners’ (RULC). The average is weighted, and then indexed to a common base year. A rising index indicates a de facto real effective exchange rate appreciation and falling competitiveness. Conversely, an index fall signifies a relative cut in unit labour costs and, thus, a competitiveness boost. The results are summarised in the chart below:
First, as an amorphous bloc, after three years of austerity the zone is starting to regain its competitiveness lost with the euro started.
Yet, second, shifts in individual members’ competitiveness remain mixed. The chart shows the absolute competitiveness shifts by country since the euro started. The large dispersion illustrates the inevitable tensions from a monetary union that has some political union, but nowhere close to enough economic union.
Third, the biggest winners still include Germany, which is important given it accounts for about a third of eurozone GDP. Germany saw its unemployment rate rising from 9% in 2001 to over 12% by 2005, but, this pain reaped dividends.
Fourth, the good news is that Spain and Italy’s deterioration is now correcting – both outright, and relative to a still improving Germany. This is shown by the reducing cluster as Spain, Italy et al gradually move back to the left. In the chart, we highlight also the up-to-2010 period (denoted by the grey spots) to show how members’ relative positions have improved since austerity kicked in, in 2010. Outside the zone, the UK’s has worsened 3% point on lower productivity, albeit from a much more impressive relative base than most euro members.
Improvement to Italy and Spain is a step forward. It raises hope that austerity is at last paying dividends, and that underlying problems are being addressed. It also gives credence to the view that the narrowing in bond spreads generated by Draghi is being underpinned by signs of real, tangible improvement.
The cost of improvement
While encouraging, it comes at a significant cost, heralding further tensions. First, lower trade flows and the drain on resources mean that strains are now impacting core members. Germany’s competitiveness may still be improving, but sustaining this will be difficult with one foot in recession, especially in election year. Underpinning France’s loss of ‘triple A’ ratings has been failure to reverse a 7% competitiveness loss since the euro. This is twice Portugal’s loss, which is a bail-out country rated 10-11 notches below France!
Second, boosting competitiveness via austerity poses, as Ireland knows, its own risks to growth and thereby deficit and debt ratios.The difficulty will be raising competitiveness via productivity gains, rather than the less attractive options of higher unemployment, falling wages and/or lower taxes that governments cannot afford.
Then there is political risk, largely absent at the start of the crisis, but now at its heart in Italy, and in Germany to September. Monetary union without political union offers unsynchronised and interrupted electoral cycles that mean politicians promising reform today may not be around to implement it.
So, on current progress, full convergence may take a decade of hard work. Meanwhile, with limited governmental risk-sharing, Draghi will have to deliver on his pledge, if he wants to stay ‘king’ of the financial markets.
