How should better governance of the EMU look like? (Part I and II)
Last week, at the margins of the latest EU summit, a high level meeting took place between Greek Prime Minister Alexis Tsipras, German Chancellor Angela Merkel, French President François Hollande and the four authors of a paper that a reader of flassbeck-economics kindly brought to our attention. The four authors in question comprise the very top of European governance: the President of the European Commission Jean-Claude Juncker, the President of the European Council Donald Tusk, the President of the Euro Group Jeroen Dijsselbloem and the President of the European Central Bank, Mario Draghi.
The paper, which bears the title ‚Preparing for Next Steps on Better Economic Governance in the Euro Area,‘ was meant to form the basis for a discussion at the informal meeting of the European Council on 12 February. It shows the direction that the politicians at the highest levels of the European institutions want to take in order to solve the euro crisis. Although the nine page hand-out somewhat modestly is called ‚An Analytical Note,‘ it is undoubtedly a very important document, given the prominence of its signatories. It reflects the political preferences and the intellectual backgrounds of the authors (and their staff) and it makes clear how they plan to approach the Greek crisis and the crisis of the euro in general. Given the importance of this text, one would expect a thoroughly researched document, written in precise language and leading to clear and logical conclusions. However, nothing is further from the truth.
The first section, ‚The nature of the Economic and Monetary Union,‘ argues that the euro is much more than just a currency. It is the concrete realisation of a political project that binds its members together in a “community of fate.“ In this community, solidarity is warranted in times of crisis. Adherence to rules that have been agreed by all members is also essential. All of this may sound great in theory, but the real question is how it works in practice. Although it is certainly not meant that way, it is not too far from an admission of failure. The political project of integration cannot advance or succeed if the monetary union fails economically. As we all know, the economy of the euro zone is not working well. Does the paper address the reasons for this failure?
The ways in which the ‚community of fate‘ currently functions is counterproductive and illogical, because, in the current framework, there are basically only two ways to deal with a member state that runs into economic problems and both of these ways inevitably lead to more trouble. The economic failure of any member state affects all other countries of the union, both economically and politically (although unevenly). So what can be done? Solidarity can be suspended, so that no loans will be given to the member state that is experiencing problems. The reasoning is that solidarity harbours a fundamental danger to the existence of the union: if we help one member state out, we need to help all the others out too, at any point in time. The keywords to describe this thinking are domino effects, turbulence on currency markets, the danger of a generalised banking crisis, an economic downward spiral through revaluation, deflation and widespread generalised uncertainty within the euro zone. However, things progressed – or rather degenerated – to the point that solidarity is considered to look bad for the standing of the euro zone. It is assumed that the majority of citizens of the countries that are supposed to finance the ’solidarity‘ are no longer willing to bear the burden. After all, why would they? Things are difficult everywhere and many people have problems to make ends meet. Therefore, the opponents of the monetary union are gaining political ground. This is undermining the union from within. Solving the core problems of EMU will be essential for the further existence of the EMU. Did the four presidents of the EU institutions develop a strategy to deal with this conundrum?
To be honest, it is difficult for me to hide my sarcasm, and, after all, why should I? We read that a monetary union can only be successful when “(…) over time it pays more to be in it than to be outside of it.“ Who would have thought that it could be the other way round? Imagine a Greek or a Spanish citizen studying this document. They are presumably nodding their heads in disbelief when they read such banalities. However, senior management personnel deemed it appropriate to include this into a paper to be discussed at the highest European level at a time of manifest crisis.
Our imaginary Greek or Spanish citizen will presumably ask if anyone of the European leadership is aware that hundreds of thousands of people in Greece, Spain or anywhere else have great trouble to make ends meet, every day again. But perhaps the European leadership just does not care about that. Whatever it is, the conviction is growing that the advantages of being in the EMU do not outweigh the disadvantages of not being in the EMU. The catastrophic conditions at present in the national labour markets did not exist in Greece or in Spain before they joined the EMU. The Greek and the Spanish national debt was much less in 1999 than it is today and durable growth and price stability, the other two EMU targets listed in the paper have been absent for many years. After more than six years of harsh economic crisis, austerity policies, high levels of unemployment and rising poverty, policy-makers in Brussels present a cost-benefit analysis proving that membership of the EMU is positive for each member state and for the vast majority of its citizens without further ado, as if this is utterly evident. This is sheer intellectual capitalism, merely stating their a priori preference. It is very clear that the EMU has not been advantageous to all member states, let alone to the majority of the populations of the crisis countries. Instead of ignoring this, those in charge of the EU should look at the reasons for this. They should make an honest evaluation of what went wrong and use these insights as the basis for changes in policy. Unfortunately, there is nothing in this text that points in that direction.
Let’s have a look at the analysis section, which bears the title ‚Looking back: The manifold roots of the crisis.‘ This section enumerates a variety of causes of the crisis: there is the financial crisis and the debt crisis of the state, there is a crisis of competitiveness and a ‚crisis of markets‘ (market failures in specific countries): none of this counts as analysis. Anyone can read up about any of this in any newspaper. But it is not all talk. The paper goes on to (finally) provide some empirical evidence in order to present its views on the essence of the euro crisis.
The paper first addresses the divergence in interest rates between the EMU countries. This is not a new information. The real question why interest rates diverged is not dealt with in any detail. The American subprime crisis hit the banks in different countries of the EMU very hard. But why did it hit some European countries much harder than others? According to the authors, in some EU countries, “(…) the good times of the first decade of the euro“ led to financial and real estate bubbles that burst in the wake of the financial crisis. But why did such bubbles originate in some countries and not or to a much lesser degree in others? And why did bubbles originate at all, given that the first decade of the euro was a “good time“? Why was the first decade of the euro a “good time“ for some, but not for others (Germany in the first and foremost), although all EMU countries followed the same monetary policy? All of these questions are important. They all remain unanswered.
According to the paper, government deficits and national debt increased dramatically after 2008, because government budgets were used for bank bailouts. Without further ado, this is declared to be the cause of the divergence of interests on government debt. Consequently, the paper turns the Euro crisis into a financial crisis and then into a sovereign debt crisis. Whether in addition to the bank bailouts, variations in growth rates in the years following the outbreak of the financial crisis are important and how these different dynamics may be explained is not discussed. Below is the graph illustrating the “sovereign debt crisis”. All of this is amazing, especially when one considers that the objective of this ‚Analytical Note‘ is to formulate a solution to the euro crisis. Here is the original (Chart 2 on page 3):
This chart presents the level of government deficits and the levels of government debt (each in per cent of GDP) for the years 1995 – 2013. The different colours divide the factors up into four phases. This is done for the euro area as a whole. Lines that reflect the passage of time connect the points. The graph clearly shows that there exist irregularities in the evolution between the two variables; making clear that there is no simple or stable relationship between them. This is all that there is to learn from this graph. Should it be possible to learn more? Once again, it is very clumsy work. The graph does not even distinguish between government deficits that are the result of countries trying to mitigate economic hardship beyond the ‚automatic‘ stabilisers in the tax and social security systems on the one hand and deficits that are caused by rising interest rates on the other hand. Distinguishing between these two types of deficits is absolutely necessary. In the first case, deficits are made in order to stimulate economic recovery and do not lead to a sustained increase in government debt – the expectation is that renewed growth will pay off. The second case, however, leads almost certainly to greater debt accumulation. By not distinguishing between these two types of deficits, there is little or nothing to see. Everything is thrown together in one pot – deficits are deficits.
Do not forget: this is supposed to be an analysis of why there are such marked differences in economic performance between the countries of the euro zone. To deal with the euro area as a whole is incomprehensible. It makes an appraisal of the economic performance of the different countries impossible. Why is this done in this way? The only reason I can think of is that, in doing so, it leaves out what individual countries have tried in order to mitigate the financial crisis. Germany was particularly involved in U.S. subprime securities due to its large trade surplus with the United States. This was the reason why Germany was hit particularly hard and fast by the financial crisis. In response to the economic downturn of 2008 – 2009, Germany initiated a comprehensive program of deficit spending. But after 2009, such Keynesian programs were seen as reprehensible by other countries and by the EU leadership. The leaders of the European institutions are not going to admit that programs that they oppose on ideological grounds had a positive effect and could have had a positive effect for the whole of the EU.
It is without doubt that such programs could have had a positive effect (as they did in Germany) in countries that seemed initially less affected by the financial crisis than Germany, but where things progressively worsened, until they finally ended up in a full-blown recession. Instead, economic policy drifted into the opposite direction when austerity was implemented. If policy-makers had differentiated between the reasons for the existence of public deficits in the different countries of the euro zone (i.e. which type of deficit?), it would have become clear that the generalised austerity approach was altogether nonsensical. But it seems that this exactly is what the ‚Analytical Note‘ wants you to not understand. Instead, it provides its readers with some graphs and with discussions that are useless in terms of understanding and resolving the crisis.
The EU paper goes on to consider the ‚crisis of competitiveness.‘ This is certainly the more exciting part of the text. To the top of the EU it is simple: nominal and real rigidities in product and labour markets are responsible for the lack of efficient allocation of resources in Europe – once again, why this is the case is not being discussed. It is dogma. According to the text, these inefficiencies decrease competitiveness in Europe. Unit labour costs increased sharply in some countries, while they remained constant or even decreased in others. This led to a loss of competitiveness in high wages countries as well as to current account deficits and overall trade imbalances.
For readers of flassbeck-economics, the relationship between unit labour costs, competitiveness and current account imbalances is nothing new, but this may not be true for the high-level EU policy-makers. In the past, representatives of the Deutsche Bundesbank, for example, and their allies, including the German Federal Government, are rejecting such considerations. It is very noteworthy that, some time ago, the Bundesbank published a calculation that proves the exact opposite of what they are constantly saying. The scenarios showed that rising labour costs in Germany lead to higher net exports. But nothing like that is to be found in the Analysis Note. Chart 3 on page 4 of the document has no other purpose than to prove the fatal consequences of labour market rigidities. A rigidity index of 2008 from the OECD is used in combination with changes in the unemployment rate from 2009 to 2013 (probably in percentage points – the reader cannot be sure as a unit designation is missing). The chart deals with 14 EMU countries. The resulting data show a rising trend (probably the product of a regression calculation – one cannot be sure). The purpose of this graph is very clear: it is nothing else than to prove the gospel that „(…) the more rigidities exist in a country, the more problems will occur in its labour market.“ Here is the graph:
This graph is extremely important because it shows what the top of the EU believes, although it makes no sense. According to the index produced by the OECD, in 2008, Germany and France had approximately the same degree of rigidity (the index unit is around 4.3). Since then, surprisingly, both countries recorded an opposite trend in their labour markets: in Germany the unemployment rate decreased from 2009 to 2013 by more than two percentage points, while in France it rose by just over one percentage point. Spain, which scores slightly lower on the rigidity scale than either France or Germany, recorded an increase in the unemployment rate of about eight percentage points between 2009 and 2013 – obviously, the lower rigidity made no difference. By far the largest increase in unemployment (about 18 percentage points), took place in Greece, although Greece does not have the highest score on the rigidity index. Portugal, where unemployment was relatively low in 2009 and where unemployment increased by six percentage points, scores highest. Austria is another point in case. Although Austria’s rigidity index is much lower than Germany’s, its unemployment rate did not decrease. It remained constant.
This chart and the discussion that goes with it contributes nothing to a proper analysis of the crisis and its resolution. Its aim consists of trying to cement the prevailing opinion that „rigidity“ is one of the essential (structural) causes of the crisis and that „flexibility“ is the magic key to overcome it. But this is nothing more than ideology. If anything, the chart shows that there is no causal relation between the represented variables: rigidity is not an explanation for unemployment. If it were, the southern crisis countries would be characterised by high degrees of rigidity, while the two largest economies of the eurozone would be characterised by low degrees of rigidity. In reality, this is not the case.
When negotiating on the basis of such ‚insights,‘ the Greek government should ask the authors of this Note by how much exactly they are supposed to destroy their labour market rigidities so that unemployment will finally decrease in Greece. Or they can inquire about the actual value of the rigidity index for Greece at the moment and ask how many years it will take before this lower rigidity pays off in terms of employment. I am sure that the Greek government would also like to know how it will keep its unemployed citizens away from starvation, especially if the government is not permitted to spend money on poverty reduction. All of this is, of course, absurd. The reason why it is absurd is that the labour market is seen as isolated from the rest of the economy – never mind bank bailouts, government deficits, deflation, recession, trade imbalances, all that is needed for unemployment to decrease is to increase “flexibility” on the labour market. But this is complete nonsense. Labour markets need to be seen as an integral part of the economy, as an essential piece in the puzzle of overall economic development.
Let’s have a look at the part of the paper that deals directly with the issue of labour costs. Over the period from 2001 to 2009, the change in unit labour costs (presumably the growth rate over the entire period – this remains unclear) is correlated with the change in the unemployment rate from 2009 to 2013. Unsurprisingly, a simple, inverse positive, relationship comes to the fore: within the EU member states, increases in unit labour costs before the outbreak of the financial crisis correlate with the loss of competitiveness and the growth of unemployment.
First of all, I do not understand where these figures on changes of unit labour costs come from or how they have been calculated. According to the Ameco database – these are data from Eurostat – overall unit labour costs increased for Germany by 7% (on average 0, 9 % per year), by 19% for France (2.2% on average), by 29% for Italy (3,2% on average), by 31% for Spain (3,4% on average), by 19% for Portugal (2.2% on average) and for Greece by 41% (4.4% on average). These are not the figures that are used in the ‚Analytical Note.‘ Perhaps the authors of the paper use unit labour costs of industry rather than unit labour costs of the economy as a whole. If this is the case, the authors made a methodological error by combining these figures with figures of aggregate unemployment.
Secondly, it is not clear why unemployment is being compared to labour costs and not, as one would expect from a neoclassical analysis, to the development of real wages relative to productivity in order to calculate the labour share in overall income. We know that exports and imports are, in most countries, not the main determinants of wages, so they are not the main drivers of wage cuts either. This is not to deny that labour costs are crucial for international competitiveness, but even neoclassical theory does not directly relate international competitiveness to rises in unemployment.
Thirdly, if you look at competitiveness, why would you only deal with the years before the financial crisis? Why is there no consideration of the development of unit labour costs since 2009? Even if some delay exists between (re)gaining competitiveness and positive effects on employment, it is of utmost importance for the evaluation of the current situation to determine the evolution of unit labour costs in the different countries after the crisis as well.
Moreover, for a monetary union it is particularly important to discuss a normal growth of unit labour costs (i.e. feasible and acceptable) since the introduction of the euro and which degree of labour cost growth could be considered as sustainable for the future. But this hot iron is not even mentioned, let alone discussed. One does not read one word in this paper on the absolutely essential relationship between the inflation target of the European Central Bank (ECB) that has been agreed upon by the members of the euro zone on the one hand and national unit labour cost growth on the other. By consequence, there is not one word on how Germany torpedoed this goal from the very start of the EMU by putting pressure on its wages so that, year after year, unit labour cost growth remained far below a level that would have been consistent with the ECB’s inflation target at the national level.
It is true, of course, that other countries also broke the so-called golden wage rule – in the opposite direction. But what was the real effect of that? An increase in overall unit labour costs from 2001 to 2009 by 1.9% a year (the inflation target of the ECB), gives a total of 16 % over eight years. The data show that Germany greatly deviated from this norm, while France and Portugal abided to it fairly well. If we look at the evolution since the start of the monetary union (which is appropriate as it is the starting point for the comparison between national price levels because from then onwards exchange rates were irreversible fixed), there can be no doubt that by 2009 the deviation by Germany from the ECB target was as big as Italy’s – but in the opposite direction. If put correctly in perspective for the period from 1999 to 2008, Germany experienced a huge competitiveness boost because of its political pressure on its labour costs. Germany’s misconduct, the difference between national unit labour costs and the ECB’s inflation target is bigger than Greece’s during the same period.
A comparison between the ECB’s target and the actual labour cost growth from 1999 to the current day shows that Germany remained far below the norm, that the three southern European crisis countries (Greece, Spain and Portugal) and France remained below it, albeit only slightly, and that Italy exceeded it. This proves that Greece, as well as Spain and Portugal, regained their competitiveness since 2009, but that these efforts failed to materialise in terms of restoring employment. The countries regained competitiveness, but unemployment did not decrease. Unfortunately, this situation will last. The deflation strategy will not create employment. Regaining competitiveness by cutting wages does not lead to a recovery of the domestic economy – the contrary is true. Competitiveness will indeed be restored, but as long as Germany remains undervalued thereby blocking external markets, including markets in the rest of the world, the result for the deficit countries will be limited. As long as Germany does not change its wage policy, the race to the bottom will continue. Furthermore, the economic stimuli due to the depreciation of the euro also benefit Germany much more than the other member states.
The graph suggests that the smallest possible increase in unit labour costs automatically and inevitably will reduce unemployment. But this is wrong for several reasons. To begin with – and this is of course exactly what has happened – if every country in the union follows the same strategy of putting pressure on wages at the same time, the end result for the union as a whole will be deflation, stagnation, and worse, recession (and, in countries such as Greece, depression) and this makes restoring employment impossible. Secondly – and this is obvious too – the desperate expansionary monetary policy of the union provokes competitive devaluation, retaliatory action in other currency areas and a destabilization of the global economy.
As long as these relationships are not properly understood and not seriously discussed and, by consequence, not recognised as the basis for a solution to the crisis at the highest policy levels of the European Union, all attempts to save the euro are doomed to fail. The paper states about the gradual build-up of divergences in competitiveness and current account imbalances up to 2009 that „The former framework for governing [the EMU – F.S.] did not include the systematic monitoring and the correcting of imbalances and therefore could not prevent their formation.“ This little sentence is very informative. It tells us that the ECB, the Euro Group, the European Commission and the European Council deny any responsibility for diverging unit labour cost growth.
Critics such as Heiner Flassbeck have warned for many years that since 1999 a storm has been brewing within the EMU. Heiner Flassbeck initiated the “Macroeconomic Dialogue” within the EU to allow for a coordination of European wage policy. But none of this ever made much of an impression. There was no dialogue. Ideological notions that wages are set in markets, that markets are never wrong, that monetary policy determines inflation, that flexible labour market will decrease unemployment, etc. block the way. During all these years, it was too much to ask to look at competing theories, compromise and sacrifice antiquated and wrong economic policies on the alter of European peace, so that the continent could have stability and prosperity. Instead, Europe was made into a laboratory of neoclassical economics – austerity at a time of deflation and stagnation, leading to human suffering unseen since the Great Depression of the 1930s.
It is unnecessary to put the last part of the analysis, the ‚crisis of markets‘ under the microscope because it is not interesting in itself. It is, however, remarkable because it represents, very much against the inclinations of the authors, an admission of bankruptcy in the faith of the market. The logical consequence of the paper is that the market is unable to create the macroeconomic conditions that are necessary to generate durable and more or less even growth in Europe. Indeed, why should market actors who, in a market economy, think and act in exclusively microeconomic ways take macroeconomic risks into account? How should that work, except by regulation from outside the market? All by all, it is painfully simple. Either market actors recognise macroeconomic risks as little and as late as possible, just as those in power that are responsible for economic policy do or they do recognise macroeconomic risks and compile series of data and facts without logical coherence, relevance or explanatory power for the economy. It really does not make a difference. The public can then be told that the work has been done well. The market-oriented politicians will make the point that they did their job, but, that, unfortunately, they do not control all the macroeconomic determinants. Everyone will be happy, the market-oriented politicians will not be criticised, macroeconomic management will be considered unnecessary and the crisis will continue unabated until it becomes completely unmanageable.
My criticism of the paper by the four presidents is not yet finished. This contribution is already very long, but it seems extremely worthwhile to me to dissect the economic thinking of those who currently carry the fate of the EMU into their hands. We will continue next week.
Translation W. Denayer