Euro-Area Periphery Faces More Pain to Complete Rebalancing
Most peripheral euro-area countries have significantly improved their competitiveness recently, but more needs to be done. With currency devaluation ruled out, further downward pressure on labor costs is likely, which will probably deepen and prolong recessions and interfere with fiscal adjustment.
Although peripheral countries can no longer adjust their external exchange rates, they have worked hard to improve their competitiveness in recent years. These “internal” devaluations (i.e. involving changes in relative costs and prices rather than nominal exchange rates) mean much of the competitiveness lost in the early years of euro membership has now been recouped.
This has been achieved by either reducing wages relative to other countries, or by increasing relative productivity, or by a combination of the two. In Greece and Ireland, wage cuts have had a significant impact on the adjustment process. Elsewhere, the reduction in unit labor costs has been heavily reliant on productivity growth. Unfortunately, this has been a blunt instrument.
In Spain, for instance, productivity has risen by 11.3% since the second quarter of 2008. But rather than technological innovation, this has been the product of huge job cuts, raising question marks over the quality and durability of the underlying adjustment.
In any case, costs and productivity are only part of the story. To get a better insight into the competitive position of the periphery, we also need to investigate export performance and current account balances.
Export performance has been pretty good in the circumstances. Since the first half of 2009, exports of goods and services have grown at similar rates to Germany in Italy, Spain and Portugal. Ireland and Greece have lagged, but there are genuine mitigating factors in both countries.
The periphery’s current account position has also improved markedly. However, the most important factor here has been the impact that chronically weak domestic demand has had on import growth. Since the first half of 2008, domestic demand has fallen by between 6.4% in Italy and more than 20% in both Ireland and Greece. The result is massive resource under-utilisation. This is reflected in output gaps—the difference between actual and potential GDP—which range from 3% in Italy to 13% in Greece, and unemployment rates, which range from 11% in Italy to 26% in Spain.
In our view, rebalancing in these countries is far from complete. Much of the improvement in real exchange rates has been due to productivity gains generated by savage job cuts. In a similar vein, much of the improvement in current accounts is due to chronically weak domestic demand and is likely to be cyclical. In other words, deficits are likely to widen again once economies start to recover and output gaps begin to close.
So further adjustment looks necessary—especially as most of these countries have huge external debts and should probably be running sizeable current-account surpluses. With membership of the euro area likely to rule out changes in nominal exchange rates, this probably means further downward pressure on labour costs. And this in turn suggests current recessions are set to be deeper and last for longer, further complicating the already arduous task of fiscal adjustment in the peripheral countries.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Darren Williams is Senior European Economist at AllianceBernstein.