The Eurozone's Unresolved Situation

10/15/2014
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The Eurozones Unresolved

Situation
Let's Fix It: Its Not Personal,

Its Business
Elliot S. Weissbluth
Sep 28 2014
289 2 1
The More Distressing, Less
Noticed Message from
Microsoft
Sallie
Krawcheck
CEO
Nadella
Can
market
forces
prevail in the Eurozone?
Will Wearables Improve Your

Jobanother
Performance,
Y bank intervention coming four plus years after the
With
roundOrofGet
central
start of the Eurozone debt crisis, this is a question worth considering, at a time
when the Southern Eurozone members - Italy, Spain, Greece and Portugal,
which collectively account for over 30% of the GDP of the early adopters of the
Euro as a whole continue to struggle.
This is a complex topic for sure, but a simple economic indicator can be used to
help frame the situation.
The Real Effective Exchange Rate, or REER, is a weighted average of a
country's currency relative to an index or basket of other major currencies
adjusted for the effects of inflation. A country with higher inflation will seek to
devalue its currency to maintain competitiveness in relation to its trading partners
(the reverse also applies of course, but these days nobody seems to want a
strong currency). The REER therefore provides a gauge of that countrys
competitiveness in foreign markets.
https://www.linkedin.com/pulse/article/20140928021814-1088431-the-eurozone-s-unresolved-situation?trk=prof-post
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Under a fixed foreign exchange regime, policy options are much more limited. A
Eurozone member can become much less competitive relative to another
member with a lower inflation rate. Stated differently, its REER will increase in
that situation. This dynamic provides an insight as to how the Southern
European countries got into trouble in the first place, and some of the challenges
associated with its resolution.
Historical Context Leading Up to the 2008 Financial Crisis
The oil shocks of the 1970s had very damaging effects in the southern
contingent of the Eurozone, with inflation rates skyrocketing. Devaluations were
therefore a necessity to regain competitiveness, although these also provided an
inflationary feedback loop. In contrast Germany, and to a lesser degree France,
more or less kept inflation under control during this turbulent period.
Figure 1: Historical CPI Inflation in Selected Eurozone Countries, 19652001

Source: www.inflation.eu.
It is important to understand this context, as these economies evolved out of a
system that systematically used currency devaluation as a policy tool for many
years.
In the 1980s, Portugal, Greece and Spain formally joined the European
Community, having just transitioned to a democratic system in the prior decade.
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A program to promote economic convergence with the European core was then
implemented. This included the establishment of trading bands with other
European currencies in order to avoid wild swings and competitive devaluations
between trading partners, as well as facilitate greater economic integration going
forward.
As currency fluctuations narrowed, inflation at home would have to come down,
otherwise the REER would increase as a reflection of higher prices for their
goods and services abroad. Figure 2 shows this process of convergence in the
Southern European countries from 1995 up until the last business cycle peak in
2007.
Figure 2: REER Yearly Index in Selected Eurozone Countries (1995 = 100),

1995-2007
Source: Eurostat.
(a) Based on the current 18 countries of the Eurozone.
Portugals currency (speaking figuratively) had appreciated in real terms by
almost 15% over that period. Spain, Greece and Italy were not far behind. At the
same time, the REER of their core Eurozone partners went in the other direction,
declining by almost 10%, and thus gradually eroding the cost advantage and
competitive edge of Southern Europe.
As shown in Figure 3, this loss of competitiveness had a very negative effect on
the trade balance (goods and services exported minus imported) down south,
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with generally expanding deficits recorded over the period.
Figure 3: Trade Balance as % of GDP, 1995-2007

Source: Eurostat.
(a) Remaining founding members of the Euro combined.
Not even Italy, with its dynamic exporting sector in the northern part of the
country, was able to buck the trend. On the other hand, the core countries as a
whole were able to increase their trade balance throughout the period.
Figure 4 depicts the situation in absolute terms in 2007. Out of 188 countries in
the world, our Southern European friends made the top 10 list ranked by current
account deficits. Spain made it all the way to #2; Greece, at #6, had net imports
of almost $4,000 per person, the highest by far in the ranking.
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Figure 4: Top 10 Countries Ranked by Current Account Deficit in 2007 (US$

bn.)
Source: CIA World Factbook.
It should also be noted that China emerged as a trading powerhouse over this
period. By 2007 it already boasted the worlds largest current account surplus.
Southern Europes industries like textiles and light manufacturing, which
historically had contributed significantly to their economies, were particularly
vulnerable to Chinese imports. This was much less so in the core countries,
which stood to gain disproportionately more from trading with Asia. So the
composition of the export sector is also an important consideration.
If we rank the Southern European countries in accordance with their trade deficit
as % of GDP in 2007, we get the same domino sequence of economies tumbling
down during the 2010-11 Eurozone debt crisis: first Greece, then Portugal,
followed by Spain, and narrowly missing Italy with the same virulence (Ireland is
not shown here, but the crisis there was rooted in a different economic model).
For all the talk about government finances, turns out that trade deficits actually
matter even inside a fixed currency regime like the Euro. Years of heavy
borrowing by the private and public sectors led to inflation in the form of relatively
higher price levels and burgeoning trade deficits, further undermining the
competitiveness of the economy at a time when the international markets were
opening up.
At some point those imports become unsustainable and foreign lenders that
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provide the credit close the tap. And thats precisely what followed.
After the 2008 Financial Crisis
Figure 5 shows how Southern Europe started to devalue in real terms as
financial conditions deteriorated from 2008 onwards. The decline in REER is
particularly pronounced in Greece, Spain and Portugal, spurred on by deep
austerity measures and a big curtailment of credit to the private sector.
Figure 5: REER Yearly Index in Selected Eurozone Countries (1995 = 100),

2007-2013
Source: Eurostat.
(a) Based on the current 18 countries of the Eurozone.
And once again we see the trade deficits responding in tandem, as shown in
Figure 6.
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Figure 6: Trade Balance as % of GDP, 2007-2013

Source: Eurostat.
The decline in trade deficits as % of GDP has been very substantial, after the
large chronic deficits of happier times [Note: GDP accounting changed in all of
these countries over this period to include things like illegal drugs and
prostitution, which in some cases added 3% to the final calculation. Hmmm]
Services Inflation
Under a fixed exchange rates regime, REER changes are fundamentally driven
by differences in the inflation rate. We can break this down by: (i) goods inflation,
which broadly reflects price changes in items that are easily traded across
borders; and (ii) services inflation, for those which are not.
With open borders goods inflation should be fairly aligned across member states.
As such, the key driver behind overall changes in competitiveness must be
services inflation. This is shown in Figure 7 below.
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Figure 7: Services Inflation by Eurozone Area, 1999-2014

Source: Eurostat, Clemente de Lucia (BNP Paribas).
Note: Periphery includes Greece, Spain, Portugal, Italy and Ireland; Core
includes the Netherlands, Austria, Luxemburg, Belgium, Finland, Germany and
France.
Going back to 1999, services inflation in the periphery was consistently higher
than in the core up until 2009. This is very much in line with the relative
performance of the REER over this period, as outlined previously.
However, with fixed exchange rates and open borders, what is driving this
significant services inflation differential?
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Figure 8: Relative GDP Performance vs Service Inflation Differential, 19982013

Source: Eurostat, Clemente de Lucia (BNP Paribas).
(a) Includes only the Eurozone founding members plus Greece.
(b) Difference between Periphery and Core services inflation rates in
percentage points.
Figure 8 shows that faster GDP growth in the periphery was accompanied by
relatively higher services inflation. With the onset of the Eurozone debt crisis in
2009, the trend reversed and the periphery started to grow much slower, as
shown in the shaded area. Services inflation responded accordingly. This makes
economic sense of course: under similar conditions, countries growing faster
should experience higher price growth in non-tradable items.
Therefore, the lack of economic vitality in Southern Europe is adding significant
deflationary pressure.
The Eurozones Unresolved Situation
Can the Southern European economies restructure their economies with the aid
of a declining REER, that is, their goods and services becoming relatively
cheaper abroad, and reverse the trend that has led to a steady accumulation of
massive trade deficits over a decade and a half?
Recent experience suggests that this could be possible. However, sustaining
that decline in the real value of the currency going forward will be very difficult
for the following reasons:
Deflation improves competitiveness outright by reducing the cost base of
the country (e.g. lower salaries). But this is very problematic for Southern
European economies, as the already stratospheric debt levels continue to
rise as the income needed to repay them goes down in nominal terms.
Which is why the European Central Bank is so concerned with deflation.
The core Eurozone partners could conceivably endure relatively higher
inflation to reduce their relative competitiveness, but this is also
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problematic: (i) as we have seen, this differential is largely driven by

economic performance, meaning that Southern Europe could be failing to
achieve the escape velocity needed to bring down debt ratios; (ii) the
inflation rate differential needed to make a difference down south would
likely to be too high for the core countries; and (iii) core countries compete
against many other countries.
Greece has already seen a massive correction in its REER, which is now
below the level in 1995. And yet the trade deficit remains stubbornly high
compared to its closer peers. It is unclear by how much more prices would
need to adjust to correct this. Sanctions against Russia, a major export
market for them, could not have come at a worse time.
Politically, devaluation is not on the table. In any event, foreign debts
resulting from a generational accumulation of trade deficits would explode
in value overnight.
The inability of these countries to rebalance their foreign terms of trade highlights
a major flaw of the Eurozone construct, which is largely based on conventional
international economics thinking.
All the talk about free movement of labor, price adjustments and so forth breaks
down once we realize the adverse implications that the required adjustments will
have on debt ratios. It looks like we have hit one major economic SNAFU.
Figure 9: Eurozone Government Debt as % of GDP, 2013

Source: Eurostat.
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Figure 9 reminds us of how extreme the debt situation has become in Southern
Europe, in this case just by looking at the public sector. In 2013, all the countries
added together had a Government Debt as % of GDP ratio of 121.5%, much
higher than their core Eurozone partners and more than double Maastricht
Treaty levels. The ratio increased by a staggering 40 percentage points in just
five years.
At these dizzying heights market forces just cant be allowed to play out; and the
debt situation in the southern Eurozone complex remains unresolved. Debt is the
one thing that has steadily grown over the last four years in these countries.
Sure, we can all live in a world where central banks continue to keep interest
rates at absurdly low levels (again, the market is not allowed to function) and
paper over any sovereign blow-ups. However, the system becomes increasingly
unstable. Moreover, the economic fundamentals continue to deteriorate as those
countries struggle to regain competitiveness under a massive debt burden. And
it is tackling that burden with non-conventional measures that eventually needs
to be considered, but thats a story for another time [Hint: that process starts with
an R].
But OK, these are very pleasant countries to live in, with friendly people, great
food and beautiful weather. For sure this can attract foreign companies and
eventually develop such a productive economy that will mitigate any pricing
disadvantages and help pay off the debts right?
And that would be excellent, except for the fact that these are pretty difficult
countries to do business in. According to the latest Doing Business Survey by
the World Bank, heres how they ranked out of 31 OECD countries: Portugal
(#19), Spain (#27), Italy (#29) and Greece (#30). Add the strong likelihood of
higher taxes and pension costs to pay for all the debts as they come due and
you might be better off just visiting.
If more goods and services dont starting leaving these countries more and more
young people will, motivated by high unemployment at home and the prospect of
a better life elsewhere. At least someone is working towards a real resolution.

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Veronica Giordano
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J.P. Morgan Private Bank

Very interesting article. Unfortunately my daughter stopped reading at the time of
" going forward". Tonight I finish it. Please keep feeding me w macro visions!!!!
Gracias! Vero
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10/15/2014

The Eurozones Unresolved Situation | LinkedIn

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Erico Matias Tavares

The Eurozones Unresolved

Let's Fix It: Its Not Personal,

Will Wearables Improve Your

The Eurozones Unresolved Situation | LinkedIn

Figure 1: Historical CPI Inflation in Selected Eurozone Countries, 19652001

The Eurozones Unresolved Situation | LinkedIn

Figure 2: REER Yearly Index in Selected Eurozone Countries (1995 = 100),

The Eurozones Unresolved Situation | LinkedIn

with generally expanding deficits recorded over the period.

Figure 3: Trade Balance as % of GDP, 1995-2007

The Eurozones Unresolved Situation | LinkedIn

Figure 4: Top 10 Countries Ranked by Current Account Deficit in 2007 (US$

The Eurozones Unresolved Situation | LinkedIn

Figure 5: REER Yearly Index in Selected Eurozone Countries (1995 = 100),

The Eurozones Unresolved Situation | LinkedIn

Figure 6: Trade Balance as % of GDP, 2007-2013

The Eurozones Unresolved Situation | LinkedIn

Figure 7: Services Inflation by Eurozone Area, 1999-2014

The Eurozones Unresolved Situation | LinkedIn

Figure 8: Relative GDP Performance vs Service Inflation Differential, 19982013

The Eurozones Unresolved Situation | LinkedIn

problematic: (i) as we have seen, this differential is largely driven by

Figure 9: Eurozone Government Debt as % of GDP, 2013

The Eurozones Unresolved Situation | LinkedIn

(a) Remaining founding members of the Euro combined.

The Eurozones Unresolved Situation | LinkedIn

Erico Matias Tavares

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