Lounsbury: EU - Euro and dangers. Wolf, FT

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May 25, 2005

EU - Euro and dangers. Wolf, FT

A timely and interesting article from my favorite bar none commentator, Martin Wolf.

My excuse for commenting on EU is quite simply the sitting here on the other side of the Med from the EU, we have to be deeply concerned about what that sick giant of an economy is going to do.

Martin Wolf: Italy's predicament exposes eurozone
By Martin Wolf
Published: May 24 2005 20:24 | Last updated: May 24 2005 20:24
http://news.ft.com/cms/s/21f25198-cc82-11d9-bb87-00000e2511c8.html

Let us think the unthinkable: could the eurozone disintegrate? The answer is yes. Disappearance of the zone as a whole seems hugely unlikely, so long as the commitment to the European project survives. But the exit of one (or more) members, a sovereign default or both is not at all inconceivable.

Warms Pantom's heart perhaps, but looking into his argument I think Wolf's thinking is close to mine.

Yet those all-powerful watchdogs, the bond markets, apparently disagree. Interest rate spreads within the eurozone are tiny (see chart). Investors apparently consider the debt of the eurozone governments as close to perfect substitutes. This is astonishing: after all, ratios of government debt to gross domestic product at the end of last year varied from Luxembourg's 5 per cent and Ireland's 29 per cent to Italy's 105 per cent and Greece's 112 per cent (on the Maastricht treaty definition). Investors must not only believe that the currency union is impregnable but that each sovereign borrower is as good as the other. The latter belief assumes that all the fiscal authorities will behave in an equally responsible manner or that there is an implicit bail-out. These assumptions are highly implausible.

Absolutely agreed. Thinking Greece and Italy have anything approaching responsible government is madness.

A number of economists argue that the European Central Bank is distorting the market by treating all eurozone sovereign liabilities as equally riskless. Even if the ECB does this only at the short end, the knowledge that it does so will affect the entire yield curve. The solution, suggest Willem Buiter of the London School of Economics and Ann Sibert of Birkbeck, in an unpublished note, is for the ECB to accept government debt as collateral only at market-determined discounts.

But can you imagine the political howling in the EU if they did so?

Now, getting on to his Italy discussion, I'd like to highlight something for thought. Italy's underlying economic problems are very.... similar I would say to the problems of the southern Med.

Whether this idea would make a big difference to prices in the market is unknowable. What is knowable, however, is that it makes little sense for anyone to treat the debt of all eurozone members as equivalent. Because of its size and status as a founder member of the European Union, Italy's predicament is the most significant. It is also highly revealing. What has happened since entry, as I noted last week ("A more dynamic eurozone is a necessity", May 17 2005), is the precise opposite of what was needed: declining productivity performance, deteriorating competitiveness, faltering growth and weakening fiscal discipline.

In its latest survey of Italy, the Organisation for Economic Co-operation and Development remarks: "It is somewhat ironic that Emu membership, by allowing sharply lower interest and exchange rates may, in effect, have relaxed the perceived need for structural adjustments on both supply and fiscal sides." It may be ironic, but it is also human - and potentially calamitous.

The scissors cutting Italy's economic lifeline have two blades: productivity and fiscal fragility.

Chart

Start with the productivity blade. Since 1995, Italy's output per hour has deteriorated by about 5 per cent against the eurozone average. This is the result of a decline in total factor productivity rather than of a (highly desirable) substitution of labour for capital (see chart). As a result, external competitiveness and potential growth have both slowed: relative to Germany, Italy's real effective exchange rate has appreciated by almost one-fifth since 1999; and potential rate of growth is now estimated at only 1.3 per cent a year.

Now consider the fiscal blade. In its most recent Economic Outlook, the OECD notes that the cyclically adjusted primary fiscal balance (the balance before interest payments) has collapsed from a surplus of 5 per cent of gross domestic product in 1998 to a forecast surplus of only 1 per cent this year (see chart). The OECD also forecasts the general government fiscal deficit, before the customary special measures, at 4.5 per cent this year and 5.1 per cent in 2006.

In order to regain lost external competitiveness, Italy must have substantially lower inflation in the costs of tradeable goods and services than elsewhere in the eurozone. Given the dreadful productivity performance, that would demand next to no increase in nominal wages over an extended period, which would also mean relatively high real interest rates. This combination would ensure even lower actual growth than Italy's already low potential rate. But that would further undermine the fiscal position. Unfortunately, efforts to shift the fiscal position back to balance would weaken the economy still more, since there are no monetary or exchange-rate offsets to such fiscal tightening.

Chart

If you think you have seen a case a bit like this, you are right: it is called Argentina. Bernard Connolly, a notorious opponent of the monetary union, even argues that the debt ratio will explode upwards, given the low inflation Italy needs and the declining potential rate of growth that Italy also has. Together, these will generate very low growth in nominal GDP (which is the denominator in the debt ratio).* He also believes that Italy has a structural primary fiscal deficit of 1 per cent of GDP. Under his assumptions, the debt ratio would rise towards 170 per cent of GDP over 20 years even if there were no rise in interest rate spreads. A fiscal (and financial crisis) would loom.

I will leave the rest for readers to ferret out, but an article well worth the read.

May 25, 2005

EU - Euro and dangers. Wolf, FT

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