Europe’s crisis-torn nations are paving an escape route to recovery.
From Ireland to Spain, the austerity demanded by policy makers in exchange for aid amid three years of debt woes is starting to deliver the competitiveness needed to restore economic growth even as the turmoil risks reigniting in Cyprus.
- Special Report: Hope Dawns for European Recovery
At the price of a doubling in unemployment and near-10 percent plunge in labor costs, the so-called peripheral euro nations are reviving manufacturing and trade. In Spain, exports reached a record 222.6 billion euros ($287 billion) in 2012. PSA Peugeot Citroen (UG) is hiring there and in Portugal.
“The countries that were highly imbalanced are undoubtedly, progressively, but very effectively, correcting these imbalances,” former European Central Bank President Jean-Claude Trichet said in a March 3 interview. “The current-account deficits of countries that have been under stress diminished over the last years considerably.”
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Elected officials are racing to translate Trichet’s rebalancing into increased incomes to avert a lost decade of mounting debt and unemployment.
Joblessness already tops 25 percent in both Spain and Greece, while protesters have taken to the streets of capitals and on at least two occasions set buildings ablaze in Athens. Just two of 14 euro-zone government leaders have kept their posts in elections since late 2009 and extremists such as Golden Dawn in Greece are gaining support.
“If declining spreads or an improved balance of payments are economically crucial, they are of little comfort to people who fear losing their job or struggle to find one,” European Union President Herman Van Rompuy told reporters March 14 after a summit eased the shackles of budget rigor.
At Morgan Stanley (MS), chief international economist Joachim Fels cites the productivity gains as reason to turn more upbeat about the euro’s longevity, rebutting the warnings of economists such as Paul Krugman and Martin Feldstein that nations may need to leave the euro to spur efficiency via a cheaper currency.
“The internal rebalancing in the euro area is progressing,” said Fels. “Some of them, especially Spain but also Portugal not to speak of Ireland, are regaining competitiveness.”
A key proxy for competitiveness is an economy’s current account, the broadest measure of trade. It shows improvement across the periphery nations whose deficit and debt woes had threatened to swamp the euro.
The combined account of Greece, Ireland, Italy, Portugal and Spain narrowed to a deficit of 0.6 percent of gross domestic product at the end of last year from 7 percent in 2008 and will be in balance later this year, according to estimates by Holger Schmieding, chief economist at Berenberg Bank in London.
While a slide in imports accounts for some of the correction, Greece boosted its exports outside the EU by about 30 percent in the fourth quarter of 2012 from the previous year, while Italy’s rose 13 percent in January from a year ago, he said.
Companies are taking advantage of the cost squeeze. Nissan Motor (7201) Co., Japan’s second-biggest carmaker, said Feb. 4 it would build a new compact family car at its Barcelona plant and invest 130 million euros after reaching an agreement on improved productivity.
Ford Motor Co. (F) said at the end of last year it will increase capacity near Valencia as it shuts plants in the U.K. and Belgium. Peugeot (UG), which is cutting workers in its home market of France, is also lifting output in Spain and Portugal.
In Ireland, U.S. companies such as EBay Inc (EBAY)., Google Inc. (GOOG) and Facebook Inc (FB). all have expanded in the past two years, taking advantage of a corporate-tax rate of just 12.5 percent compared to Spain’s 30 percent.
Investors can benefit from the “structural reforms which can transform Europe’s competitive landscape” by anticipating gains in stocks, says Aaron Barnfather, who helps manage the equivalent of $140 billion as director of European equities at Lazard Asset Management Ltd. in London.
The metamorphosis is known as internal devaluation -- the result of the policies demanded by German Chancellor Angela Merkel as the cost of Europe’s pre-eminent power backing bailouts. Prevented by membership of the euro from driving down currencies, governments and companies are squeezing labor costs to spur productivity.
By making goods relatively cheaper to churn out, a country’s products become more attractive to overseas buyers, mirroring the effect of a weaker currency. That creates new engines of growth, replacing domestic demand hurt by government spending cuts or the collapse of ailing local sectors such as Spanish property.
The approach still provokes criticism. Nobel laureate Joseph Stiglitz calls the mix of internal devaluation and austerity a “toxic combination.” Forcing down wages and prices will only increase the debts of governments and families, he wrote in a column for Project Syndicate this month.
Without exports, Europe’s performance would have been even worse in recent years. Ireland’s economy would have been 4 percentage points weaker without net exports since 2008, Greece’s 3 points and Portugal and Spain 2 points, according to Citigroup Inc. Trade deducted from growth in the pre-crisis years.
The forced restructuring resulted in Spain reducing social-security payments from companies, raising the retirement age, making it easier to fire workers in downturns and preventing unions from clinging to boom-time wage deals.
Portugal weakened collective bargaining, cut redundancy payments and suspended four national holidays. Greece pared public-sector wages, lowered the minimum wage, and eased redundancy rules; it intends to sell state-controlled companies like betting monopoly Opap SA (OPAP).
A February study by the OECD showed Greece scoring 0.92 out of a possible one for meeting the pro-growth policy changes suggested by the club of rich nations since 2010. Ireland and Portugal scored about 0.8 and Spain about 0.7.
For citizens of Europe’s periphery, the downside of the economic revamp in these initial stages is lower wages and greater unemployment.
The euro area as a whole, with an average unemployment rate of 11.9 percent in January, is suffering its second recession since 2008. A slump this year would result in the first back-to-back annual contractions since the euro’s introduction. Italian voters are rebelling at the ballot box against reforms and austerity there.
“In the periphery, there are dark clouds in the form of recession and unemployment,” said Huw Pill, chief European economist at Goldman Sachs Group Inc. in London and a former ECB official. “But there is a silver lining to these clouds in the form of an adjustment process that is necessary, albeit painful.”
While Pill says it may take years to return economies to full health, calculations by his team suggest transformation is under way.
On average, the periphery is about halfway to eliminating large structural current-account deficits, which allow for declines related to recession-driven weaker import demand, estimates Goldman Sachs (GS). Greece, Portugal, Spain and Ireland also now need to reduce their real exchange rates by about 10 percentage points less than they did two years ago.
The price they’ve paid has already been steep on the basis of lower wages.
A November study by Berenberg and the Lisbon Council, a Brussels-based research group, found unit labor costs fell 10.5 percent from 2009 to 2012 in Greece, 10.3 percent in Ireland, 6 percent in Spain and 6.1 percent in Portugal. Over the entire euro-area they gained 1.5 percent.
By contrast, Germany’s fell 4.1 percent from a peak in 2003 to a trough in 2007, a period which helped revive what was once the Sick Man of Europe and which is now credited with enabling it to have dodged the worst of the crisis.
The OECD today published an index showing that relative labor costs in Spain and Portugal have now dropped below Germany’s for the first time since 2005.
The test is whether the cheaper and greater availability of labor is enough to attract investment and hiring or ends up leaving economies a wasteland. Youth unemployment has already surged, with about half of Spaniards under 25 jobless, and a third of Greeks facing poverty.
“It’s potentially good for the economy but only if it results in faster investment,” said Bert Colijn, a Brussels-based economist at the Conference Board and co-author of a January study suggesting economic reform may be having a positive effect. “If not then there’s a downward spiral risk.”
It’s the mirror image of the euro’s first decade, when historically low interest rates in the periphery fueled inflationary spending booms, reflected in credit bubbles and deteriorating current accounts and government budgets.
Irish home prices quadrupled in the decade through the mid-2000s and those in Spain more than doubled. Greece’s budget deficit ballooned to 15.6 percent of GDP in 2009, while Portugal’s widened to 10.2 percent.
The good times began to unravel in 2009, when Greece admitted its budget math was wrong, sparking a crackdown by investors on fiscal profligacy and investment excesses.
Interest rates spiked from Dublin to Madrid, with the yield on Ireland’s eight-year bond reaching a record 15.7 percent in July. Spain’s 10-year bond yielded 7.75 percent the same month. Credit default swaps insuring Spanish debt peaked at 640 basis points and those for Ireland hit the equivalent of 1,181 basis points.
Following four bailouts, a semblance of calm was restored after ECB President Mario Draghi’s July 2012 vow to do “whatever it takes” to defend the euro.
Still, the crisis risked blowing up anew this week after European finance chiefs agreed to an unprecedented tax on Cypriot bank deposits as part of a 17 billion-euro rescue. The absence of a government in Italy and Greece’s struggles to meet the terms of its bailout present other flashpoints.
Spanish credit default swaps are now under 300 basis points and Ireland’s below 200 basis points. It now costs Ireland 3.7 percent to borrow for eight years and Spain 5 percent for a decade.
The rebalancing challenges the likes of Princeton University’s Krugman and Harvard University’s Feldstein, who repeatedly recommended some nations consider taking time out of the euro to regain competitiveness via devaluation. Krugman told Bloomberg Television on Feb. 15 that he is surprised Greece hasn’t left the euro yet, though an exit is “more likely than not.”
“The costs of staying in and making the euro work, while high, are less than the costs of exiting or try to break it up,” said Barry Eichengreen, a professor at the University of California, Berkeley, and an author of a history of the European economy.
That’s not to say the price of membership isn’t painful or will bear fruit soon. The smaller trade imbalances really reflect a collapse in demand for imports as consumers and companies hunker down, says Thomas Mayer, an economic adviser to Deutsche Bank AG. The Frankfurt-based bank this month cut its forecast for the euro area to show it contracting 0.8 percent this year rather than the previously predicted 0.3 percent.
“At this stage it is still demand destruction which has helped current-account deficit countries balance their accounts,” said Mayer. “It’s not a healthy situation.”
Economists at Societe Generale SA (GLE) calculate that with the exception of Ireland, unit labor costs have risen since 2008 if no change in employment is assumed. They also say countries will need to run even healthier current accounts than now if they are to stabilize the debts they owe abroad.
Those with hope look to Germany as a model after it revived its economy from the overhaul following the fall of the Berlin Wall. Pushed through by then-Chancellor Gerhard Schroeder, the so-called Agenda 2010 was a package of labor reforms and welfare cuts.
While it prompted strikes as unemployment reached a 12.1 percent post-war high and contributed to Schroder’s electoral defeat, it is credited with reducing Germany’s unemployment rate to a post-reunification low of 6.8 percent in December 2011.
“No one is snickering at Germany’s economic model now,” German Finance Minister Wolfgang Schaeuble said in a March 14 speech to Bloomberg’s Germany Day conference in Berlin.
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