The fate of weaker member countries in the euro zone


The ECB was forced to cut interest rates by 25 basis point last week as the economic forecasts showed tepid growth in the euro zone next year and falling inflation through 2015. The initial forecast of growth was 1.4 percent and is now revised down to 1.1 percent. Some analysts even believe that deflation may set in the euro zone next year. To support their argument, euro zone inflation fell to just 0.7 percent in October 2013, the lowest since the depth of the financial crisis and below Japan’s for the first time since 1998.

The ECB economic chief sounds a little more optimistic than what the projection suggests. He said and I quote “although there is a lot of slack in the economy, the risk of deflation seems remote at the current juncture”. The immediate concern is with the economies of both France and Spain. France is expected to have a budget deficit of 3.7 percent, much higher than the 3 percent required by the Maastricht agreement. The economic growth forecast for France was revised from 1.1 % to 0.9 %. This is bad news as the deficit will only increase. Spain is expected to have their deficit increase from 5.9 percent to 6.6 percent and their economic growth rate is revised down from 0.9 percent to 0.5 percent.

All these data suggests that an economic slowdown is in the offing combined with lower inflation rate. Any austerity measures will drive these economies to further slowdown and may cause real hardships to their citizens. Is there a solution to this situation? All eyes are on Germany. Germany has its own problems. It has maintained a very large current account surplus of 235 billion dollars this year (nearly the same as China). This export surplus creates its own challenges. Martin Wolf, a financial times columnist describes this vividly. Here is the extract of his analysis.

Export surpluses do not reflect merely competitiveness but also an excess of output over spending, Surplus countries import the demand they do not generate internally. When global demand is buoyant, this need not be a problem provided the money borrowed by deficit countries is invested in activities that can subsequently service the debts they are incurring. Alas, this does not happen often, partly because the deficit countries are pushed by the supply of cheap imports from surplus countries towards investing in non-tradable activities, which do not support the servicing of international debts. But in current conditions, when short-term official interest rates are close to zero and demand is chronically deficient across the globe, the import of demand by the surplus country is a “beggar-my-neighbour” policy: it exacerbates the global economic weakness.

It is no surprise, therefore, that in the second quarter of 2013 the eurozone’s gross domestic product was 3.1 percent below its pre-crisis peak and 1.1 percent lower than two years before. Its highly credit worthy core economy is subtracting demand, not adding to it. Not surprisingly, the eurozone is also stumbling towards deflation: the latest measure of year-on-year core inflation was 0.8 percent. Since demand is so weak, inflation may well fall further. This is not only risky pushing the eurozone into a Japanese deflationary trap but thwarts the necessary shifts in competitiveness across the eurozone. The crisis-hit countries are being forced to accept outright deflation. This makes ultra-high unemployment inescapable. It also raises the real value of debt.

The policies pursued by the eurozone, under German direction, were certain to have this outcome, given the demand-destroying impact of the all-round fiscal austerity. In a recent paper for the European Commission, Jan in ‘t Veld argues that contractionary fiscal policy has imposed cumulative losses of output equal to 18 percent of annual GDP in Greece, 9.7 percent in Spain, 9.1 percent in France, 8.4 percent in Ireland and even 8.1 percent in Germany, between 2011 and 2013. Inevitably, monetary policy is going to find it almost impossible to offset this. Before the crisis, it could work by expanding credit in what turned into the crisis-hit countries – above all, in Spain. Today, it is working against the background of a weak banking system, debt overhangs in crisis-hit countries and an aversion to borrowing in creditor counties.

The most likely way that a more aggressive monetary policy would be effective is by depreciating the euro’s exchange rate. If, for example, the ECB were to undertake large-scale quantitative easing, by buying the bonds of the members in proportion to their shares in the central bank, a falling euro would be the most likely result. But that would exacerbate the tendency of the eurozone, operating under German influence, to force its adjustment on the rest of the world.

As the vulnerable countries shrink their external deficits, while the chief creditor country remains in surplus, the eurozone is generating huge external surpluses: the shift from deficit towards surplus is forecast by the IMF to be 3.3 percent of eurozone GDP between 2008 and 2015. Given the shortfall demand in the eurozone, the shift might need to be even larger, at least if the vulnerable nations are to have much chance of cutting unemployment. This is a beggar-my-neighbour policy for the world. The US has every right to complain about past US regulatory failures.

It will be impossible, however, for the eurozone to achieve prosperity on the basis of export-led growth: it is too large to do so. It has to achieve internal rebalancing, as well. Hitherto, as the IMF’s October World Economic Outlook shows, it is mass shedding of labour that has raised competitiveness, and collapsing domestic demand that has reduced external deficits in the crisis-hit countries. Thus  the adjustment successes have been the other side of the coin of economic slumps and soaring unemployment. Yet, even so, the IMF does not forecast significant reductions in net liability positions. Their vulnerability will endure.

So what, in brief, is happening? The answers are: creeping onset of deflation; mass joblessness; thwarted internal rebalancing and over reliance on external demand. Yet all this is regarded as acceptable, desirable, even moral – indeed, a success. Why? The explanation is myths: the crisis was due to fiscal malfeasance instead of to irresponsible cross-border credit flows; fiscal policy has no role in managing demand; central bank purchases of government bonds are a step towards hyperinflation; and competitiveness determines external surpluses, not the balance between supply and insufficient demand.

These myths are not harmless for the eurozone or the world. On the contrary, they risk either trapping weaker member countries in semi-permanent depressions or leading, in the end, to an agonising break-up of the currency union itself. Either way, the European project would come to stand not for prosperity, but for poverty; not for partnership, but for pain. This, often, is a tragic story.

The debate at hand is whether the eurozone was created to make Germany richer and powerful and at the same time to promote slavery, hardship and economic dependence among the peripheral eurozone countries. Let us wait for the final outcome.

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