Eichengreen on Possible EMU Break-Up

In a new NBER working paper, Barry Eichengreen presents an in-depth analysis of the odds and possible consequences of a break-up of the euro area. (Unfortunately, the full-text is only available to subscribing institutions, but you can find a draft version on Barry Eichengreens’s personal website.) The paper is the most comprehensive and coherent analysis of the political economy of a possible EMU break-up so far, even if one concludes studies distributed by investment banks such as HSCB, Société Générale, Morgan Stanley or Deutsche Bank to their clients only.

Eichengreen first draws a distinction between the different motivations behind a possible exit from EMU: First, there might be an incentive that stability-oriented countries like Germany might leave EMU as the inflation rate achieved for EMU as a whole is too high for their taste (a scenario which was first invented by Deutsche Bank’s Thomas Mayer and marked the first post on Eurozone Watch a little more than a year ago). Second, there might be countries like Italy and Portugal which have lost competitiveness to such a degree that they have an incentive to use a depreciation to gain competitiveness and get themselves back to full employment.

Eichengreen sees large technical problems (even larger than what has been argued on Eurozone Watch), but more limited political problems with a country leaving EMU. According to him, the reintroduction of the national currency would need adequate time to prepare, a time in which one could expect large capital flights. On the other hand, he believes that politically, a country leaving EMU would be reduced to “second-class status” in negotiations over other EU issues. Different from some other commentators, however, he believes that the country leaving EMU could do so without leaving the EU completely.

Economically, he remarks that the literature answers the question whether the debt and/or competitiveness problem of a country leaving EMU could be solved by reintroducing the Euro. Without a change in the underlying wage-setting or fiscal structure, a depreciation is unlikely to resolve the issues. His own empirical analysis, however, points toward a possibility that the increase in financing costs for a country leaving EMU could be counteracted by fiscal reforms which guarantee a more responsible future fiscal policy.

When it comes to policy options to improve the stability of the euro area, Eichengreen recommends to lower hurdles for labour migration between euro area countries so that asymmetric shocks can be bolstered by workers moving to other countries. When it comes to fiscal federalism or a EU insurance mechanism with transfers to countries in economic dire straits, he questions the viability, given the “lack of national identity” and the “lack of political solidarity”.

While the Eichengreen paper thus presents a large amount of very stimulating material, in our view, he neglects some important aspects: First, his economic arguments against leaving EMU might have less weight in the real world: Policy processes are sometimes extremely messy, and political candidates might have higher discount rates and different utility functions than the electorate. As Charles Goodhart has argued, a surge in the poll numbers of some Italian candidate who is publicly toying with the idea of leaving EMU might be enough to lead to a capital outflow which might force the government in question to leave EMU (something similar happened in Brazil in the run-up of the 2002 Lula election, when only a record IMF loan rescued the country from default).

Second, if some politician has a very short time horizon (technically: a high discount rate), he/she might value the short-term stimulus from a strong depreciation and a depreciation of the public debt higher than future financing costs (see here for a paper with that argument), thus opting for an EMU exit even if it is not optimal for the country as a whole.

We therefore believe that the risk for a political crisis in EMU (with a renewed debate about some country leaving the monetay union) will continue to re-emerge over the coming decade and we would estimate this risk to be somewhat higher that Eichengreen believes (who concludes that the exit of a single or more countries from EMU cannot be “ruled out”).

We also differ from Eichengreen in his reform proposals and evaluation of their viability: First, while further increasing hurdles to migration might increase mobility somewhat, labour mobility for a long time will remain much below that in the US. Given different languages, different cultures, but also very different business customs in different EMU countries, migration for the middle class will always come with some destruction of their human capital. While a construction worker might easily move from Lisbon to Berlin without a loss of productivity and the same might be true for a fund manager moving from Frankfurt to Paris if she is working in an English-speaking environment, the same is definetly not true for a bank clerk becoming unemployed in Germany. In Spain, he would most likely not be reemployed in a position adequate to his qualification because he might not be fluent in Spanish and might not know the customs.

Second, we are more optimistic for further fiscal integration in Europe or at least for improvements of the EMU’s fiscal framework, among others by introducing more cyclically-sensitive elements into the budget and a EMU-wide unemployment insurance (see our posts here and our – more academic – working papers here and here). In our eyes (whis we believe is well supported by Eurobarometer surveys), citizens of EMU are much more inclined towards further European integration and a EMU-wide unemployment insurance than the national politicians want to make us believe.

That being said, everyone who is interested in the debate on a possible EMU break-up must not miss Eichengreens paper.

Clemens Fuest Text

Der wichtigste Grund für diese Initiative ist die Sorge, dass Arbeitnehmer mit mittlerer und niedriger Qualifikation zunehmend von der allgemeinen Wohlstandsentwicklung abgekoppelt werden könnten. Dass diese Gefahr besteht, ist nicht von der Hand zu weisen. Viele empirische Studien kommen zu dem Ergebnis, dass die Einkommensschere zwischen hoch und niedrig qualifizierter Arbeit sich immer mehr öffnet. Allerdings stellt sich die Frage, ob der vorgeschlagene Fonds das richtige Instrument ist, um diesem Trend entgegenzuwirken.

Der Fonds schafft zunächst lediglich Anreize haben, Ersparnisse in den neuen Fonds zu verlagern, statt sie anders anzulegen. Es mag auch dazu kommen, dass einzelne Haushalte mehr sparen als bisher. Aber vermehrte Ersparnisse ändern noch nichts Wesentliches an der langfristigen Einkommenssituation der sparenden Haushalte, sie verlagern in erster Linie Konsum in die Zukunft. Die entstehenden Kapitaleinkünfte sind überschaubar. Zwar kommen die geplanten staatlichen Zuschüsse dazu, die könnten Menschen mit niedrigen Einkommen aber auch durch direkte Transfers zu Gute kommen.

Darüber hinaus stellt sich die Frage, in welchem Verhältnis der Deutschlandfonds zur privaten Altersvorsorge steht. Wenn die geförderte Ersparnis ebenfalls langfristig sein muss, sind die Wirkungen jener der Förderung privater Altersvorsorge ähnlich. Es droht eine Dopplung der bürokratischen Vorgänge bei der Administration der Förderung. Wenn die geförderten Ersparnisse hingegen schon nach kurzer Zeit für Konsum verwendet werden dürfen, erhält der Deutschlandfonds eher den Charakter einer Ansparhilfe für die Anschaffung von Autos, Fernsehern und anderen Konsumgütern. Auch das ist wohl kaum beabsichtigt.

Für den Deutschlandfonds wird auch angeführt, dass er die Identifikation der Arbeitnehmer mit ihrer Firma stärke. Gleichzeitig wird erkannt, dass es unter dem Aspekt der Risikostreuung problematisch sein kann, wenn Arbeitnehmer in dem Unternehmen ihr Geld anlegen, in dem sie auch beschäftigt sind. Gerät das Unternehmen in eine Krise, verlieren sie nicht nur ihren Arbeitsplatz, sondern auch noch ihre Ersparnisse.

Der Deutschlandfonds will dieses Problem wie folgt lösen. Erstens sollen die Arbeitnehmer durch den Fonds an allen Unternehmen beteiligt sein, nicht nur an dem Unternehmen, in dem sie arbeiten. So wird zwar für Risikostreuung gesorgt. Die Identifikationswirkung der Mitarbeiterbeteiligung geht allerdings verloren. Um diese Wirkung wieder herzustellen, soll der Fonds nur den Unternehmen Kapital zur Verfügung stellen, deren Mitarbeiter Fondsanteile erworben haben. Das ist aus zwei Gründen fragwürdig. Erstens wird die Identifikationswirkung der Mitarbeiterbeteiligung begrenzt sein, wenn die Beteiligungserträge vom Erfolg des eigenen Unternehmens weitgehend unabhängig sind. Zweitens steht die Bindung der Beteiligungsentscheidung an die Fondsanteile der Mitarbeiter im Widerspruch zu einem anderen wichtigen Gestaltungsprinzip, das für den Fonds gelten soll:
Der Regel, dass der Fonds professionell geführt wird und sein Geld in den Unternehmen anlegt, die den höchsten Ertrag versprechen.

Man kann es drehen und wenden, wie man will. Der Spielraum für eine positive Rolle eines Deutschlandfonds ist angesichts der bereits vorhandenen Instrumente zur Sparförderung begrenzt. Das Fondskonzept selbst ist widersprüchlich. Es erscheint vielversprechender, der drohenden Erosion der Einkommensperspektiven in den mittleren und niedrigen Einkommensschichten durch die Förderung von Erziehung, Bildung und Ausbildung entgegenzuwirken.

Spain faces a macro risk – not just a construction sector risk

The current woes in the US housing market have also drawn attention to the situation in Spain. The reason for this is not hard to see: There are striking similarities between the two countries with respect to the development in both house prices and construction activity over recent years.

The current problems in the US market for Residential Mortgage Backed Securities (RMBS) have also been mirrored – if to a lesser extent – in the market for Spanish Cédulas where spreads have widened since the start of this year. Furthermore stock prices – measured on a total return basis – also seem to be discounting some kind of underperformance of the Spanish economy to come: While Germany’s DAX30 has risen by 20 % since the start of 2007 and EuroStoxx50 by 11 %, Spain’s IBEX35 has gained a relatively meagre 6 %. The consensus of economic forecasters puts the economic outlook for Spain at a rate of real GDP growth at 3.8 % for 2007 and 3.0 % for 2008. That would be some deceleration but not a lot below the average rate of expansion by 3.4 % per annum for the 2001 to 2006 period.

As will be argued in this article, the case can well be made for a (much) more pronounced slowdown in Spain’s economic activity. Our current forecast at Union Investment for real GDP growth in 2008 stands at a mere 2.2 %, i.e. clearly below consensus. This is not because we are pessimistic for growth either on a global scale or EMU in particular. In fact, we are quite upbeat for the European growth prospects with a forecast of 2.5 % for 2008 relative to 2.3 % in the consensus forecast. Where we beg to differ, is that we see a strong case to be made that Spain’s economy is not just characterised by a sector risk in construction, but that the corporate sector is in insufficient shape to withstand an adjustment in that sector. That is quite in contrast to the US experience where healthy corporate balance sheets have provided a sufficient buffer to avoid a full-blown crisis stemming from the housing sector adjustment.

Let us now first take a look at the Spanish housing market which has shown a very remarkable boom: in 2006, 658,644 housing units were completed and construction of 760,169 housing units was started. To get this into proper comparison: in the 1990s the respective figures were 267.000 and 292.000 per year. So residential construction activity has more than doubled since then. Another comparison would be to compare the number of housing starts to the population, which stands at 40.4 million in Spain. So in 2006 housing starts where sufficient to provide 2 % of the population with new housing. If we take the corresponding figure for the US at the height of the recent construction boom (2.3 million housing starts) relative to a population of 300 million this would have been sufficient to provide 0.8 % of all Americans with new housing facilities. All told, the Spanish construction boom has been extraordinary both in comparison to past experience and relative to the US.

Residential construction accounted for 9.3 % of Spanish GDP in 2006. That is almost twice the average of G7 countries. Also, it is not only residential but also non-residential construction that has boomed. So almost 18 % of GDP are now construction related. As are over 50 % of total loans on the books of Spanish banks.

These figures, of course, only illustrate that there could be some problems down the road, if the boom of recent years were to reverse. But what can give the confidence that this is likely to happen at all or even in the near-term future?

The recent experience in the US suggests that there are three potential triggers for an adjustment in the housing market – all relative to the average rate of mortgage interest. Rental yields, i.e. the level of rents relative to the purchasing price of a home, individual wages and house prices themselves. The first two of which are already flashing negative signals and the last one coming into dangerous territory right now. Let us examine the triggers in turn:

If the rental yield is higher than the average rate of mortgage interest, the purchase of a home is economically sensible because owning is cheaper than renting over the longer term. Until the end of 2003 the Spanish market has seen a difference between the rental yield and mortgage rates of roughly two percentage points. From end-03 to end-05 the rental yield has been slowly but steadily eroded as the growth in rents did not keep up with the rise in home prices. Since early-06 the successive rate hikes by the ECB have driven up the mortgage rate from a low of 2.8 % to 4.4 %. Since November 2006 the rental yield is below the mortgage rate. Put simply: Renting is now economically more attractive than buying.

As for the second trigger, if the mortgage rate is below the rate of growth of individual income the ratio of personal debt relative to income is going to decline even if there were no amortisation of the underlying debt. Although nominal growth in aggregate wage income has been running at almost 7 % over recent years, most of this increase was driven by rising employment rather than individual wages. Since 2006 mortgage rates are once again above the growth rate of individual wages. Meaning that the servicing of mortgage debt will now mean more restraint if the ratio of debt to income is to be kept stable.

Last but not least, a rate of home price inflation above the prevailing mortgage rate means that the worth of the home is rising faster than the debt burden even if there is no debt servicing at all, i.e. if even interest costs are serviced by taking out new mortgage loans. This condition is still being met with home price inflation running at 5.8 % year-over-year and the average mortgage rate at 4.4 %. The difference is eroded fast, however, due to continued ECB rate hikes on the one hand and home price inflation cooling due to the other two indicators pointing in a negative direction on the other.

One question that is always raised in this context is, of course the impact foreign purchases play in that story. Indeed, there is a fairly high correlation between external buyers in the Spanish housing market and price appreciation. However, one has first to put the magnitude into context. At the very peak of external purchasing activity in early 2003, these transactions amounted to 0.9 % of Spanish GDP and have halved since then. Apart from that, foreigners will be driven by the same rationale as domestic buyers, i.e. affordability and economic pay-off. The chances that foreigners will come to the rescue in an environment in which is does not pay to own a home should not be regarded as high.

Next, there is the question of why Spain’s ability to cope with a retrenchment in the housing market should be more limited than the one in the US. The answer to this is an entirely different situation in the corporate sector. Part of all our economic analysis at Union Investment is a stringent examination of flow-of-funds statistics especially with regard to the health of the nonfinancial corporate sector. The basic rationale here is that all income flows that have a direct nexus to production originate from this sector (the Ricardian assumption of the wage fund). Then we take a look at how much money flows back to the corporate sector via sales. The difference between the two measures is known as the savings or financing gap. The financing gap can be formally defined as retained earning plus depreciation minus investment spending. In normal times it is slightly negative as investments do not have to pay off in the period of their acquisition. If the savings gap of the corporate sector deteriorates, growth is normally accelerating. This is in line with Schumpeter’s famous statement that the entrepreneur uses (credit financed) funds to make an advance contribution to economic growth. Economic booms are therefore associated with deteriorating financing gaps and rising leverage, while slumps are characterised by broad-based retrenchment and decreasing leverage in the nonfinancial corporate sector.

It is here where one can find the striking difference between the US and the Spanish macro developments during the housing boom: In 2000, the US financing gap of nonfinancial corporations stood at -3.5 % of GDP and gross debt at 97 % of GDP. Since then, the financing gap has narrowed to -0.2 % and gross debt was reduced to 79.4 % of GDP. The US corporate sector thus has no fundamental problem to withstand the shock of the housing slump and replace construction as a driver of economic activity. It is even quite surprising that the corporate sector on the far side of the Atlantic is still in such a good shape this far into the economic upswing. By contrast, the Spanish corporate sector exhibited a financing gap of -5.1 % of GDP in 2001 which has until 2006 deteriorated further to -8.1 %. Gross debt has risen from 66 % of GDP to 106 % of GDP over the same period.

The Spanish corporate sector seems, from our perspective, extremely close to a retrenchment itself – even if there were no problems in the housing market. If fact, there are only two other countries we evaluate on a regular basis that have ever come close seeing corporate financing gaps of the magnitude prevailing currently in Spain. One is Japan in 1990, the other is Portugal in 2000. The experience of corporate retrenchment in both cases in the following years has been anything close to pleasant.
With regard to Spain, there is now one open question and one piece of hope. The open question relates to the adjustment within a currency union. Central to a successful retrenchment in the corporate sector is the ability to increase sales and/or reduce costs, i.e. some other sector has to step in to fill the void. This could either be households, the state or the rest of the world. With Spanish private household finances also being stretched, only the government and the rest of the world can do the trick. The open question and the piece of hope both relate to the external sector. The good news for Spain is that the start of the adjustment might come at a time when the world economy is generally in good shape.

Japan had to do its bit at a time when world trade suffered from three consecutive shocks – the US recession of 1991, the breakdown of the European Monetary System of 1993 and the Asian crisis of 1997/98. Portugal had to start its adjustment in 2001 amid the turmoil of the bursting tech-bubble of 2001. While Japan is now out of the woods, Portugal continues to ail. Mostly because it has been unable to improve its price competitiveness vis-à-vis its European trading partners. This can be tracked to the continuation of high pay increases relative to productivity and other European countries.

It will remain to be seen whether Spain can pull off this trick faster than its western neighbour. But it seems a fair bet to envisage a significant slowdown relative to the recent past in Spain even if the general environment remains benign.

David Milleker is chief economist of Union Investment and a regular guest contributor to Eurozone Watch.

How to limit pro-cyclical fiscal policy in EMU

We have just published an article in the German weekly DIE ZEIT calling for a reform of European budgetary rules in order to limit the national governments’ pro-cyclical fiscal policies.

We start from the observation that fiscal policy once again is turning pro-cyclical in a number of European countries. Germany is cutting corporate taxes and increasing discretionary spending at a moment when the economy is growing with rates close to 3 percent (see our post here). France’s new president Nicolas Sarkozy is cutting income taxes for home buyers and overtime payment in a boom, providing an ill-timed boost to the economy (see post here) and the Italian government has just increased their deficit target from 2.3 to 2.5 percent of GDP inspite of strong tax revenues (the money supposedly will go into more social spending).

We thus pretty much see a repetition of the mistakes made in the New-Economy-Boom 1999/2000 when governments increased spending and cut taxes so much that in the following downturn they were forced to then cut spending or increase social security contributions pro-cyclically.

As we have argued before, this pro-cyclical policy is harmful, not only in a downturn, but also in an upswing. First, fueling the boom increases the risk that the ECB overshoots with its interest rate hikes while trying to limit inflationary pressure. Second, according to recent economic research, stronger amplitudes in the business cycle might dampen long-run growth as it lowers the steady-state spending of companies on research & developments. The current fiscal policy in EMU is thus a real obstacle towards reaching the targets of the Lisbon agenda.

In the ZEIT article we therefore propose to use EU fiscal policy to limit the national excesses of fiscal policy. We therefore propose three major elements of reform:

1. Money from the EU budget should be disbursed in a more counter-cyclical manner. Over the past years, money from the structural funds have for example fuelled the Spanish construction boom at a moment when the sector was already bloated. A possibility would be to slow building projects in a boom and expedite them in an upswing.
2. The EU budget should be financed by a cyclically sensitive tax. We propose a European tax on corporate profits. With a tax rate half today’s average in the EU, the whole European budget could be financed. In addition, each country could levy an additional tax, pretty much as it is the case in the US today. This tax would also introduce a minimum level to limit harmful tax competition.
3. A European unemployment insurance should be introduced. This insurance would drain purchasing power from booming regions and thus limits the overheating of a boom, while it would funnel money into regions in dire straits. This insurance could be organised as a basic insurance which could be topped up by additional national benefits.

These proposals would not only put some stabilization into the EU budget. It would also limit the leeway for harmful pro-cyclical national fiscal policies. By putting one of the most cyclical tax at the European level, the national governments will have less possibility to misinterpret cyclical revenue increases as structural. By pulling the unemployment insurance partly on the European level, there will be less possibility to cut contributions in an upswing or benefits in a downturn (as it has happened for example in Germany over the past years and is set to happen again in 2008).

Now would be the moment to move forward with sensible proposals like that especially as Sarkozy has already put the governance of the euro-area on the table. It would be a good idea for Germany to become an advocate of these reform proposals to provide a counter-weight for Sarkozy’s proposals which might well move euro-zone governance in a harmful direction if left uncontested.

German Fiscal Policy: Pro-cyclical again

This week, the German government has been debating its budget for 2008. While everyone in the grand coalition seems to be content that finance minister Peer Steinbrück has managed to increase spending, cut taxes and cut the deficit at the same time, there are signs that the government is repeating the mistakes of the red-green government: As I argue in today’s Financial Times Deutschland (full German text here), fiscal policy is turning pro-cyclical once again.

The impressive improvement of the German budget situation (the Kiel institute sees a balanced budget for the government as a whole – including social security, states and municipalities – already in 2007) is more a result of strong tax increases than of very recent spending restraint. Especially corporate taxes have risen strongly. From 2005 to 2006, revenue from the “Körperschaftsteuer”, the federal tax on corporations, has risen by almost 60 percent.

Spending, on the other hand, has been low thanks to falling transfers to the unemployed. Beyond these monetary transfers, Steinbrück’s predecessor Hans Eichel has kept a lid on spending, but Steinbrück has relaxed the stance again. Government spending ex transfers has been growing on average by 0.5 percent from 2002 to 2005, but has picked up since. The Kiel institute now sees an increase by 2.3 percent this year and 3.4 percent next year.

Add to this a cut in unemployment contributions planned for the beginning of 2008 and the corporate tax reform which will cost € 6.5 bn in the first year after enactment according to the federal ministry of finance (and up to € 10 bn according to critics) and you again have a clearly pro-cyclical fiscal policy. This can also be seen by the fact that the Kiel institute now sees a growing headline deficit for 2008 (0.1 percent of GDP instead of a balanced budget in 2007) – and this in the wake of a strongly expanding economy.

The danger is that the money is again missing for a sensible stabilization policy once the boom ends. Germany might then again go for pro-cyclical budget consolidation – the same mistake which has helped keep the country in quasi-stagnation from 2002 to 2005.

Eurozone Watch has long argued that the governance structure of EMU is prone to pro-cyclicality in fiscal policy. Given that recent economic research hints that pro-cyclicality might actually hurting the long-term growth prospects, this is more than a mere nuisance.

Italy may jump ahead leaving its government behind

From outside Italy, it is often hard to understand what is going on in the country. We have thus asked Benedicta Marzinotto from the University of Udine and Chatham House to explain the current economic and political situation to us.

The latest available data for the Italian economy have surprised on the upside. As early as September 2006, the Italian government was expecting 2007 economic growth to pick up by only 1.1% from the previous year. Now the forecast is for this year’s national output to rise by 2.3% from 2006 (updated on 8 June 2007). This comes as largely unexpected, not least because Italy is back into political turmoil against the difficulties in passing any piece of legislation when the government majority is as thin as 3 seats ahead of the opposition (in the upper house).

What lies beneath Italy’s stronger outlook? What are its fiscal policy implications? And, why is the political situation not a threat to the possible recovery?

First of all, the news about the Italian economy experiencing a rebound in economic activity should not be exaggerated. At the end of the day, in 2006, Italy registered a growth rate of 1.9%, which that was still below the euro-zone average and that followed a year in which growth had been nil. Apart from this, there is no doubt that the country is doing better than generally expected thanks to a strong export performance that owes to the German upswing. Thus, domestic industrial production has been rising mainly thanks to external demand of capital and intermediate goods. According to ISAE (Institute for Economic Studies and Analysis), Q2 industrial output should grow by 0.6% from the previous quarter after some deceleration in Q1. At the same time, however, private consumption remains overall subdued even if, in the first quarter, it was rising at its fastest since 2004. The underlying weakness of consumer spending is also a consequence of the fact that Italian authorities opted for a significant rise in fiscal pressure over the last year to finance public deficit reduction. As a matter of fact, fiscal pressure rose to 42.3% from 40.6% in 2005 following a 12.4% increase in direct taxation. Looking ahead, the prospect is rosy. Germany will continue growing as export-led growth should feed to the consumer. It will drive Italian GDP upwards! The latest available survey-based data confirm the optimism of Italian producers, who admit the rise in orders of capital goods from abroad, and especially from France and Germany. In addition, the fact that Italian inflation is decelerating and reached in May a rate of 1.9% -slightly below the ECB’s inflation target and below German inflation for the same month (2%)- speaks in favour of a slight gain in intra-EMU competitiveness, and thus of a possible further strengthening of the country’s exports.

Strong economic growth is a blessing for public coffers. Because discretionary fiscal measures are based on government GDP growth projections, faster-than-expected growth has maximised incomes from revenues creating a bunch of financial resources (the so-called “tesoretto”) now at the disposal of government authorities. Meant to anticipate the main contents of the government’s 2008 financial bill, the financial planning document (Dpef) due on 28 June is expected to provide some indications regarding the possible destination of the “tesoretto”, whilst the entity of these resources remains subject of debate. The OECD presses for Italy to use the extra-revenues to reduce the country’s enormous public debt, which in 2006 reached 106.8% of GDP against an average of 69% in the rest of the euro-zone. At present, the government is in consultations with the social partners, whom have to be consulted by law before the submission of the Dpef. Provided that there are really resources left over from the previous financial year*, the most likely scenario is that half of them is used to finance the public debt and the other half utilised to improve the welfare of dependent workers, those that have mostly borne the costs of greater fiscal pressure over the last year, considering that the bulk of the additional revenues came from direct taxation that typically hit those that are in dependent work. The benefits should take the form of some relief on the so-called ICI, a tax which owners of real estate, be it buildings, building sites and land, have to pay to the local government, whatever the use and destination of the property.

The other burning issue on the agenda is pension reform. In 1995, Italy put in place one of the most ambitious pension reform of all EU countries. That reform foresaw adjustments to the system every 10 years. The previous government under prime minister Silvio Berlusconi failed to change the co-efficient used to calculate pension entitlements to reflect rising life expectancy. At the same time, the Berlusconi government had passed a law that raises the retirement age to 60 from 57 starting with January 2008. Still, it is unlikely that the current government agrees to increase the retirement age at once. The most likely outcome is for a gradual increase compounded by a system of incentives that rewards those that remain longer in employment. Labour unions might accept this compromise now that the government has agreed to increase minimum pensions by 250 euros in 2007, allowing also for a progressive adjustment to the costs of living in subsequent years.

So far, it all appears business as usual, namely the economy moves in cycles and the politics is just about striking compromises.
There is but one paradox that characterises Italian economics, and not for the first time, and that is unseen in any other European country: the economy can actually flourish, as it is doing now, even if the political situation is in anguish. Prime minister Romano Prodi is in fact finding it difficult to keep his heterogeneous coalition together. It did not help that deputy finance minister Vincenzo Visco was involved in a scandal that saw him transferring a few tax-police officers that were investigating on the failed attempt by the Italian insurer Unipol to take over Banca Nazionale del Lavoro. And the latest financial police scandals have unveiled a sick relationship between politics and economics that resembles the financial scandals of the early 1990s that had brought to the collapse of the First Republic and, with it, of the country’s entire party system. This time, the transition should be smoother than that but not less traumatic. The current government will remain in office until the electoral law is changed and until the centre-left has clearly identified a strong and convincing alternative to centre-right leader Silvio Berlusconi. The spotlight is on Walter Veltroni, the current major of Rome. Yet, to succeed, he needs to bring in a completely new political class: not an easy task!

The puzzle here revolves around the reasons why political instability has not compromised consumer and business confidence. It’s almost as if Italian consumers got so accustomed to instability that they have become immune to political cycles. On their part, the Confederation of Italian industry (Confindustria) is protesting against the government’s lack of activism but it can actually got it alone. The recent recovery is engineered outside Italy and is thus immune to changes in the political situation. The downside is that an export-led recovery might be not sustainable without a comforting and supportive political situation at home. Germany is a case in point. Here, all the traditional manufacturing sectors have been able to resist international competition thanks to government-sponsored investment in research and development, which in itself is a guarantee of the fact that the recent rebound may well be sustainable**. There is but hope for Italy too! Italian producers can self-sustain the current recovery under two conditions. One is that they get a better access to venture capital, provided that EU legislation becomes more venture-capital friendly. The second, strange as it may seem, is that Confindustria -which is also the national employers’ associations- exploits its direct relationship to workers. It is time for a bipartite social pact between employers and employees that recognises differences in productivity across sectors, but that also concedes relatively generous wages to unions in exchange for their willingness to accept further (unpaid) general training and training in IT skills, after the long period of wage moderation in the private sector following the elimination of the wage indexation system in the early 1990s***. Education and training are key to a rise in labour productivity, a structural weakness of the Italian system especially in the service sector. Confindustria needs to abandon the most classical liberalism to accept that, in the absence of a government that sustains consumption by means of generous transfer payments to the most needy or in the absence of a government all together, only wage bargaining can do the job!

* Tito Boeri and Pietro Garibaldi, “Dal tesoretto nascosto al Dpef”, in: www.lavoce.info, 22 May 2007.
** Marcello De Cecco, “Germania, cosa c’è dietro il boom”, in: La Repubblica, Affari & Finanza, 11 June 2007.
*** OECD, “Economic Survey of Italy 2007: Italy’s key challenges”, Paris 2007.

Misplaced scepticism about Germany’s growth potential

Recently, a debate has developed on the long-term growth perspectives of Germany. Wolfgang Munchau and Susanne Mundschenk from Eurointelligence.com have asked me to contribute my views for their website. Here is my – rather optimistic – evaluation:

Not even a year ago, most economists doubted that the German upswing would last beyond the end of 2006. In fact, Germany’s leading academics at that time were still questioning whether the Germany economy would be able to grow by 2 percent in 2006, with forecasts for a significant growth deceleration for 2007 being the norm. Bert Rürup, head of the “council of wise man” advising the government in economic questions said in May 2006, he would be satisfied if growth even reached the government’s forecast of that time, 1.6 percent for 2006.

One year later, with the German economy growing at robust rates, the skeptics have moved to another arena, questioning whether the German economy will be able to sustain this pace of growth. Now it is no longer doubted whether Germany can experience a cyclical upswing, but whether the potential is large enough to allow a growth rate of two percent or more over the medium term.

Adam Posen and Wolfgang Munchau have been the most prominent skeptics. Adam Posen argues that the fact that the German upswing so far has been very intensive in employment (latest figures on regular employment run about 2.5 percent year-on-year) but has relied relatively little on productivity growth hints that German potential growth remains at around a rather dismal 1.5 percent. Wolfgang Munchau comes to similar conclusions, claiming that there have been no meaningful reforms in the education system and the financial sector which could have increased productivity growth and thus potential growth. He also concludes that the most recent upswing in productivity (see chart 1) is rather cyclical than structural.

In my opinion, these conclusions rely on an overly mechanistic understanding of the interaction of potential growth and the business cycle, especially in the wake of past labour market reforms. Both the experience of the United States in the 1990s and ideas from the New Growth Theory hint that these concerns may be overdone. Instead, it looks well possible – and plausible – that Germany is just on a good path to increase its medium term growth performance.

Chart 1

If one looks at the economic data for the U.S. in the early 1990s and Germany now, there are a number of interesting parallels. The U.S. recovery after the 1990/1991 recession started out with very strong job growth. In 1995, the number of persons employed rose with year-on-year rates of up to 3.5 percent (see chart 2). Productivity growth, on the other hand, was weak – in fact much weaker than in Germany today, with efficiency in the American economy barely growing (see chart 1). The reason behind the slow productivity growth was that the welfare reform had increased the incentive to work for the low-qualified and that the cyclical upswing now pulled into the labour market by the millions. As these workers were less productive than the average U.S. worker, this lowered the average productivity.

Chart 2

Something similar is happening in Germany at the moment. Employment is growing strongly with productivity growth picking up only slightly. The labour market reforms, especially Hartz-IV, have increased pressure on the low-qualified to seek employment. An increasing number of Germans now is in low-paid employment, but also receives unemployment assistance, some combination that acts almost like a negative income tax. The number concerned is not trivial: In the past 12 months, the number of long-term-unemployed has fallen by roughly 300,000; the number of people receiving assistance in addition to labour income has grown by 300,000 from early 2006 until October 2006 (more recent data is not available). 300,000 jobs equal a little more than one percent of the number of regular jobs in Germany. Outside the labour market for the low-qualified, German productivity growth is impressive. Gesamtmetall, the employer’s federation for the metal sector, puts current productivity growth in its member companies at a staggering 7.6 percent year-on-year (albeit one has to note that this is productivity growth per employee rather than per hour worked).

The interesting question raised by Adam Posen is: What is happening when the vast pool of unemployed is exhausted and put into employment. Here again, a look towards the U.S. might be helpful: In America, growth did not stop at the moment when the low qualified were absorbed into the labour market. In the late 1990s, employment growth was only comparably weak, while productivity growth suddenly improved. On a microeconomic level, firms started to invest more in productivity enhancement when they were not able to hire cheap labour anymore. In addition, the effect which statistically depressed productivity growth due to the inflow of unqualified labour into employment vanished. It took until 1998 that U.S. productivity growth persistently rose above two percent. Consequently, the economy managed to continue to grow with rates of about 4 percent, even faster than in the years before when employment growth was high. There is no reason why something similar should not happen in Germany.

Second, it is highly questionable if productivity growth is simply enhanced by improving the structure of the education system or of the banking sector. Instead, there are good arguments that these reforms are neither necessary nor sufficient conditions for a pick-up in productivity growth. This again becomes evident if we take a look at the United States over the past 15 years. At the beginning of the 1990s, when the U.S. economy was just getting out of the recession, the general mood about the medium and long-term prospect of the U.S. was grim. General perception was that the education system was a mess (with the possible exception of the top-end institutions of higher education), high-school drop-out rates were high, and even the share of functionally illiterate among the high-school graduates was significant. The lack in education, so the perception of that time, were behind the underperformance of U.S. productivity growth vis-à-vis Germany or Japan.

Interestingly, the concerns about problems of the U.S. education system were completely forgotten when productivity growth in America picked up in the late 1990s. It is safe to say that the broad education system in the U.S. was not improved much over the decade – neither on the high-school level nor on the level of many of the community and state colleges in which the larger part of the American workforce receives its secondary education. Even today, the average performance of American high school students is rather weak in international comparison. However, these problems did not hinder U.S. productivity growth from picking up around the turn of the century.

So, what had happened in the U.S.? Economists still do not completely agree, but the mostly accepted story is that the strong investment in equipment, IT infrastructure and software since the late 1990s and the dissemination of this technology through the economy has made the productivity increases possible which were then harvested in times of good cyclical growth. This is exactly what New Growth Theory would teach us to expect. Technological progress is embodied in new capital goods and its benefits are felt only with a time lag after the initial investment.

German companies might not have invested as much as their U.S. counterparts in IT infrastructure after the bust of the New Economy bubble, but it is safe to say that all larger German companies by now are fairly up-to-date when it comes to IT equipments. Internet, E-Mails, Blackberries and even supply-chain management in retailing is not much behind that of the U.S. The productivity gains experienced in the U.S. over the past years should thus also be possible for German companies. In addition, capital spending on equipment and software has picked up sharply lately. Measured as a share of GDP, Germany has now higher investment in new equipment than the average of the euro-zone, a change in relative positions compared to 2002 or 2003. Given that the new equipment comes with the latest technology (and often some components which enhance their productivity by the use of latest IT technology), this investment boost can be expected to have also positive effects on total factor productivity.

A final argument of the growth sceptics is that German companies have not been investing much in research and development and are thus not well positioned for an improvement of their products in the years to come. However, even this fact might quickly change. As we know from recent work by Harvard economist Philippe Aghion, in economies with imperfect credit markets, firms vary their R&D expenditure strongly with the business cycle. As a number of German companies have been credit-constrained due to problems in the banking sector from 2001 to 2005, this effect might be important to understand the German R&D dynamics. Now, with profits growing strongly, firms have more liquidity to invest in their R&D projects and there is a lot of anecdotal evidence that they are indeed pursuing this path.

So, Adam Posen might be right that the current upswing in Germany has not been triggered by an exogenous increase of the growth potential and especially productivity. However, the elements are in place that the German upswing will endogenously increase the German potential and thus generate the improvement in productivity necessary to sustain a long and upswing with annual growth rates of two percent or more.

The implications of the EU summit for EMU governance

The results of the EU summit have been extensively commented since last Sunday. However, we at Eurozone Watch believe that a number of aspects which are relevant for economic governance in the EMU have not been elaborated in the debate so far.

The first concerns the decision to eliminate free competition from the European Union’s objectives. Firstly, we in principle agree that free competition need not necessarily be listed as an objective of the European Union. Free competition is an instrument to achive growth and international competitiveness, not an end in itself. Thus, the case for the elimination from the Union’s objectives can be argued, without necessarily questioning as such the concept of free competition within the Single Market.

The potential political consequences of the highly symbolic decision to change the objectives defined in the European Union Treaty under the current circumstances yet have to be carefully assessed. Eliminating competition from the Union’s goals is the major concession to the French President Nicolas Sarkozy. It is “sold” as a response to the mostly leftist critique in the French debate on the Constitutional Treaty which stamped the EU’s Common Market and competition policies as a Trojan horse of globalisation. Last week-end’s decision was celebrated as a major victory by Sarkozy in some French media. Some interpretations went as far as celebrating the beginning of an end to competition as a functioning principle of single market.

Does the decision mean that the functioning of competition is at risk once the new Treaty enters into force? The EU Commission in our view will not be automatically weakened. It still possesses the same means to pursue its previous tasks in subsidy and merger control. But, in order to affirm its role, it may even toughen its implementation of the EU’s competition policy, especially as national protectionism within the EU’s borders has increased in recent years.

So, instead of bringing relaxation, the decision to change the Union’s goal may turn out to be another element that fuels tensions between the Commission and the national EU governments. Given the reflex by national policy makers to engage in anti-Brussels-rhetoric, these developments may in fact lower public support for integration. After all, with the Coucil’s decision to revise the Union’s goals which have been part of the EC’s Treaties ever since integration started, expectations were raised that something would substantially change. But there is not much reason to assume it really will.

On the contrary. If tensions on the EU’s competition policy rise, they will make the still embryonic discussions on the question whether the EU competition policy as such has to be reformed in view of global competition surely more difficult. The fronts between those which argue the case for a revision of the policy (notably its underlying concept of the relevant market) in oder to promote the emergence of “European champions” and those who cling to the traditional concept of a maximum of competition within the Union’s borders to bring about globally competitive players, are likely to harden.

From an EMU perspective, it would be infortunate if these developments led to even lesser dynamics in the integration of the markets. The political will to go forward notably with the integration of capital, labour and services markets has in any case declined in recent years, as the steps that would be coming up next touch on the more sensitive issues, given the degree of integration already achieved. Insufficient market integration yet remains one of the obstacles to a smooth functioning of the EMU, especially as the fiscal regime in EMU likewise does not meet the challenges of a currency union.

The second aspect concerns the overall tense political climate at the summit. The German government had set itself a huge task to forge a compromise on the new Treaty’s elements before launching the Intergovernmental Conference. The most problematic conflicts of interest where between the “ratifiers” and the EMU-outs (Poland, the UK, the Czech Republic). France and the Netherlands, both non-ratifiers after failed referenda but Eurozone countries, contributed less to the complications to the summit (although they, in contrast to the non-ratifiers who did not even attempt to ratify the Treaty, indeed had a legitimate case to make after a democratic rejection of the Treaty).

Despite this seeming harmony between the Eurozone countries, it also has to be seen soberly that none of the EMU countries coalised to create an outreaching political impulse to the EU or EMU. From that perspective, the EU summit and its result in our view (and in contrast to many of the relieved comments in the mass media) didn’t as such create any potential for future dynamics.

The summit, yet, confirmed one tendency we commented on amply before: Nicolas Sarkozy again positioned himself as the dealmaker (which was actually the Presidency’s job) and he seems willing to act as an agenda setter in EU affairs as of now and up to the French EU Presidency in the second semester 2008.

Well before the EU summit, he announced that he would await last week-ends meeting and the end of the German Presidency before he comes forward with suggestions how to reform the Eurozone (he announced a French-Italian initiative on that matter). His first occasion to put his ideas up for discussion will be the July Ecofin meeting – which he as as French Head of State will attend against all EU traditions along with his new Finance Minister Christine Lagarde.

As a third aspect we underline that last week-end’s results are likely to contribute to asymmetric integration processes (two-speed or core Europe). The UK negotiated further opt-outs, which – at times of the Maastricht Treaty were the big exception with the EMU – now form part of European normality. The tendency towards patch-work coalitions along certain policy areas will increase. They are there already, most visibly since the start of EMU (with the UK, Denmark and Sweden being long-term opt-outs), but also in other policy fields such as justice and home affairs.

If the UK effectively makes use of its new options, the consesquence will be that the barely hidden political gap between the UK and continental Europe is likely to widen. The flip side of this general trend to lesser symmetric integration may be that the Eurozone affirms its status of the core of Europe. Political dynamics to establish the currency zone also as a political Union are yet to follow. The UK, with its newly demonstrated interest to opt-out from policy fields, will be less and less able to prevent a further institutionalisation and deepening of the Eurozone – if this is what the EMU countries decide to go for, of course.

Is Sarkozy’s “fiscal shock” the right thing for France?

Third part of our series on Sarkozy and Europe

After his election as a president, Nicolas Sarkozy did not lose any time pushing forward with his economic and fiscal policy agenda. Even before the first round of the parliamentary elections this week-end (in which Sarkozy’s party did extremely well), a number of legislative initiatives have been prepared to be pushed through the Assemblée Nationale over the summer. According to Sarkozy, France needs now a “fiscal shock”.

Among the measures brought forward by Sarkozy are the following (initiatives with little or no macroeconomic effect or costs have been omitted):

• Overtime payment: overtime payment will be excluded from taxes and social security contribution. For full time employees, this applies to all voluntary hours in excess of the original 35 hours work-week. For part-time employees, tax free overtime may only reach 10 percent of the regular work time. In addition, the companies’ social contributions for overtime will also cut. However, this money does not necessarily end up with the business sector: At the same time, the legal overtime surcharge small companies have to pay will be increased from 10 to 25 percent.
• Working students: Students will be exempted from the income tax
• Mortgage subsidies: New home buyers will be allowed to deduct mortgage payments up to a certain amount from their taxes for the first five years after having acquired a new house or apartment.
• Inheritance taxes will be cut.
• Limit on direct taxes: No one will have to pay more than 50 percent of direct taxes (social security contributions excluded), starting on January 1, 2008.

All in all, the costs of these proposals add up to probably as much as € 15 bn, or 0.75 percent of French GDP. Measures introduced into the legislative process last Wednesday already amount to € 11 bn. So far, Sarkozy has not presented any ideas of how to finance this spending spree, but his call for a “fiscal shock” and his attacks on the Stability and Growth pact hint that he is going to increase the government deficit.

To judge these measures, the important question is: What does France really need at the moment? Our regular guest contributor David Milleker, chief economist of Union Investment, has long argued that France needs some supply side reforms bolstering the profitability of the French corporate sector (see his contribution for the Financial Times Deutschland’s website here or his comment to our post on the “TVA sociale” here). David used to argue that the profitability of the French corporate sector is low in international comparison and that thus investment is low. Since supply side reforms tend to suppress demand in the short run, David has been in favour of a combined approach of supply and demand policies for France.

A look at the investment ratio in France supports David’s analysis of problems of the French business sector (see figure). Investment in equipment as a share of GDP has long been trailing behind the rest of EMU. In addition, while investment has picked up sharply in Germany, it has only risen slightly in France. This might be an indication that the French corporate sector indeed is not in a very good position, most likely because the French economy has lost price competitiveness vis-à-vis Germany in the past years of aggressive German wage restraint.

Thus, if Sarkozy would use a strategy of combined supply and demand policies, improving competitiveness while bolstering domestic demand, there would not be much to object. If he would for example introduce his “social VAT”, increasing the VAT tax while cutting social security contributions (as the Germans have done) and at the same time use his fiscal policy to bolster demand so that the VAT shock does not hit the domestic economy, this might amount to a wise strategy. One could also make the point for relaxing rules about employment protection and at the same time hand workers a tax cut, as this would also improve supply conditions while limiting the short-term negative outfall on demand.

However, Sarkozy’s program does not meet this aim. There is basically nothing in the proposal which improves France’s competitiveness. While Sarkozy has said that he would replace the large number of different labour contracts in France by one which provieds less protection, nothing to this end has been introduced in the legislative process and there are no specifics about his plan known yet. It remains to be seen if Sarkozy will ever come back to this project. However, even if employment protection is slightly loosened, this will provide little help to France’s ailing productivity.

The proposed cut in taxation on overtime is set to be redistributed to a large share towards the households as Sarkozy is at the same time increasing the mandatory overtime pay. The taxation limit to 50 percent will most likely only apply to very wealthy individuals and will not help the corporate sector much. Relieving working students from income tax will most likely lead to new strategies to have someone counted as a student, not to lower labour costs. Most students do not earn enough to profit from this exemption anyway. The cut in marginal taxes on overtime will increase the French’s willingness to work beyond their 35 hour week, but labour shortages have not been a problem for the French economy over the past years, so the positive macroeconomic effect of this measure should be small. In fact, the cut in taxation for overtime payment might even jeopardize the Lisbon target of increasing the employment ratio: Under the new rules, relative to the status quo, it becomes more attractive having the old employees working longer hours than hiring new workers. In the context of women’s participation in the labour market, some extra hours for the husband might now seem more attractive than women remaining in the labour force.

In addition, the demand stimulus from Sarkozy’s program is hard to evaluate. The tax deductability of mortgage payments might well have quite a higher multiplier: As the new tax rules might lead to an even stronger house price increase as hitherto, this might also give another boost to the French consumption which is driven by the wealth effect. However, one should note that this increases the risks for a bursting of the bubble in the real estate market and serious consequences for the economy further down the road. The cuts in the inheritance tax and the limit on overall direct taxation in contrast will only have very limited effect.

Thus, overall, it is safe to say that Sarkozy’s measures so fay rely only on demand stimulus, something which the French economy does not really need given the already strong demand in the rest of Europe and the still robust growth in France (the OECD sees French GDP growth at 2.2 percent both for this and next year). France’s problems, on the other hand, are not really tackled. For the rest of the Eurozone, Sarkozy’s policies are quite dismal: France is now fuelling the boom exactly at a moment in which the ECB is debating on how high it has to raise the interest rate in order to prevent the European economy from overheating. This is exactly the kind of fiscal policy a monetary union does not need.

Eurozone Watch nominated for Satin Pajama Blog Award

For the third time in a row, the blog “A fistful of Euros” is conducting its poll on the “Annual Satin Pajama Blog Award”. For the first time, Eurozone Watch has been nominated in two categories: “Best Economics Weblog” and “Best New Weblog”.

So far, we are doing quite well in the “Best Economics Weblog” category (especially given that we are a little late actually alerting our readers about that competition – the polls opened on May 23 and this post dates from May 27), at the moment behind only a fraction of votes behind Nouriel Roubini’s blog.

So, if you wish us luck, go to the Afoe website and vote for us – its fun and free. Click on the banner below: