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Letter from Germany: On balance, some good news for the Euro

Michael Burda on the silent real depreciation within the Eurozone relative to Germany and the slow rebalancing over the past decade

Time for some good news! Southern Europe seems to be on its way to recovery and regaining relative competitiveness within the European Monetary Union. Since the Global Financial Crisis, GDP per capita within the Eurozone has diverged dramatically. The periphery countries (Greece, Ireland, Italy, Portugal, and Spain) were hit hard by fiscal austerity measures following an explosion of debt burdens and, in the south, a sustained loss of competitiveness following the “China shock.” Many of my august German colleagues were convinced that an internal devaluation of the extent necessary to rebalance trade was simply impossible. I was on record in 2012 that the “Hume mechanism” – or a “Churchill-Brüning-deflation” in the eyes of critics – could rebalance the monetary union, albeit at a slower rate than under clearly specified no-bailout rules for member states (https://cepr.org/voxeu/columns/hume-hold).

Like the US, the Eurozone imposes a one-size-fits-all monetary policy on a large set of heterogeneous regions. Unlike the US, its sub-units are sovereign countries with different languages, national preferences, rules and regulations. American-style labour mobility is difficult in Europe, although the new influx of migration appears more mobile at the margin than expected. Capital mobility is hampered by lack of significant progress on capital market union. The EU lacks a serious fiscal policy and a tax-and-transfer capacity. The burden of adjustment falls squarely on goods markets of member countries. Prices are less than perfectly flexible in the short run, so fiscal austerity measures that followed the sovereign debt crisis led to a protracted recession in the EU periphery.

My own recent bicycle tour of the Dolomites has made me an optimist that the Euro can work. But hard data are always more convincing than touristic impressions. Consider the following facts:

  1. Debt/GDP ratios in the periphery are falling. With its inflated GDP numbers, poster-child Ireland is way out in front, cutting its ratio from 120% in 2013 to 40% in 2023. Without the benefit of foreign FDI, Greece has shown similar fiscal discipline over the past five years, reducing its ratio from 210% in 2021 to 160% this year. Part of this was the recent surprise inflation that raised nominal GDP without lifting indebtedness. But it also reflects real efforts to increase primary surpluses. Even Italy stopped its rise in government indebtedness, despite the ravages of Covid-19.
  2. Growth has returned. Real GDP per capita in Greece, Italy, Portugal, and Spain has only recently reached levels attained in 2008 but is growing once again, and significantly faster than in Germany, which is in technical recession.
  3. Competitiveness is improving. This can be seen in the relative price of nontraded goods and my own dining experiences in southern Europe. Long before the pandemic, taxis and hotels were looking more affordable. In the light of climate change and with the right supply-side policies, these countries can deliver much more than tourist destinations. The EU Green Deal, improvements in electrolysis technology and an abundance of solar energy will make these economies natural exporters of hydrogen and renewable energy, likely with German technology and investment capital in the background. With lower labour and energy costs, they will attract energy-intensive industry, too.

Good news for the periphery, bad news for the centre. Relative to most of its EU neighbours, Germany has experienced a slow appreciation over the past 15 years. Measured from peaks in 2008-2010, the GDP deflator relative to Germany’s has fallen by 21% in Greece, 12% in Italy, 5% in Portugal, and 14% in Spain, a trend confirmed by harmonized consumer price indexes. The ratio has also fallen in Finland, France, and Ireland. The tepid German recovery predicted by the IMF goes beyond high interest rates and reflects deeper concerns.

First, significant relative price changes are sowing seeds of a distributional struggle not seen since the 1970s. Rising energy prices faced by households and firms led to demands for redistribution, which were initially satisfied by untargeted and expensive subsidy measures. These have now expired, exposing lower real wages and profitability. Emboldened by manpower shortages and the government, labour unions seek to claw back lost purchasing power. Businesses threaten loudly to move to the US or elsewhere in the EU. The Chancellor called for further increases in the minimum wage from 12.41 currently to over 14 EUR/hour. This will further erode the low-wage sector and make it more difficult to employ Syrian and Ukrainian refugees and other migrants looking for work. Germany needs these people in the healthcare, hospitality and retail sectors.

Second, roughly 50-60% of Germany’s electricity is renewable, making it among the most expensive in the industrial world. While there has been an investment boom in solar panels, heat pumps, wind generation stations and the power grid, this equipment is increasingly manufactured abroad. A flood of cheap Chinese imports has already wiped out solar cell manufacturing, while import competition is eroding other industries of German pre-eminence, meaning chemicals, metals, machine tools, and the automobile sector. International competitiveness is the top subject raised by employers’ associations and industry lobbyists.

Finally, recent successes of extreme right-wing parties as well as those on the far left have cast doubt on the political stability of the present government, even though the possibility of “Dexit” seems remote at the moment. Slamming the door on immigration would intensify labour shortages already in the pipeline. Capital flight to Germany has subsided and is likely to reverse itself as the recovery of southern Europe accelerates. Recent reports of real estate price recovery in Greece, Italy, and Portugal support this assessment.

Michael Burda, 19 June 2024