No End in Sight – The Downward Spiral towards Europe’s Lost Decade

In the last two months several think tanks and international organisations such as the IMF and the OECD painted a rather grim picture of Europe’s economic future. For example, in its latest Interim Economic Assessment the OECD projected a sluggish growth of just 0.8% for the euro area, which had already experienced a contraction in the year before. And earlier in August, the European Central Bank (ECB) published new inflation figures, which should raise serious deflationary concerns even among the most orthodox monetarists around. To be sure, those among us who have been suspicious of our leaders’ obsessive-compulsive attempts to inaugurate the end of the euro crisis will not be surprised by these alarming statistics. What does surprise, however, is the resilience with which European governments stick to a failing path. One example: recently on BBC Newsnight, Kirsty Wark interviewed French Prime Minister Manuel Valls and asked him what he thinks about France being labelled as Europe’s new ‘sick patient’. While being slightly consternated by the arrogance of the question – France’s economy is still considerably larger than the UK’s – Valls did not hesitate to identify his country’s allegedly largest problem: competitiveness.

“Our problem which we explained very clearly from 2012 onwards is the competitiveness of our businesses. In ten years we have lost considerably margins compared to Germany. We are implementing a plan that involves reducing by €40bn [£31bn] the contributions labour costs and taxes on businesses. (…) We have too high deficit. Not because of public expenditure but because growth in France is too low. And inflation is too low to bring the deficit down. So like Germany from 2000 onwards we need growth.”

To be fair with Valls, who replaced the more left leaning Jean-Marc Ayrault as Prime Minister in April this year, he did emphasise the need to focus on growth, which in austerity-ridden Europe is somewhat of a refreshing rarity. But what is anything but a rarity is the stubborn belief that by merely copying the ‘German model’ economic growth will emerge almost automatically. What has Germany actually done to become some sort of a new Sweden? What has it achieved to emerge as a country which other governments are obsessively keen to use as a role model for fiscal policy? Well, Valls and his colleagues are right in that point, it is very much all about competitiveness. Germany consistently ranks high among the top export nations, and until 2009 the government has been proudly awarding itself a title which even for fans of neologisms is a pain in the ear: Exportweltmeister (‘export world champion’).

But is that really a model which can help the rest of Europe escape its dire straits? It is a well-known fact that Germany’s economy is highly dependent on its export industry, while domestic demand has been pathetically weak over years. Indeed, when the world economy slumped in 2009, Germany was hit harder than most other euro members, due to its disproportionally high exposure to the world market. However, its current account surpluses still make up roughly 7% of its GDP. There are several problems associated with that high dependency on exports. The first has already been mentioned: an export-oriented economy is necessarily more vulnerable to external shocks. In fact, in light of the collapsing demand across Europe, Germany’s exports have recently declined, causing the most renowned economic institutions to downgrade their growth forecasts for Europe’s largest economy. Secondly, huge imbalances within a monetary union must be avoided in order to create a so-called ‘optimum currency area’, a term coined by economist Robert Mundell to describe the ideal economic environment for a currency union. It took the European Commission ten years to realise this, when in 2011 it finally introduced the Macroeconomic Imbalance Procedure (MIP). Germany who has the second largest intra-European trade surplus (€44.6bn [£35.1bn]), has repeatedly exceeded the 6% threshold above which, according to the Commission, trade surpluses cause imbalances. As a matter of fact, six of Germany’s ten most important export destinations are euro members with France being at the top.

It certainly does sound promising when the largest economy of the euro area has a positive current account and growth rate. That is why policy-makers and commentators often use the metaphor of Germany being the economic engine of the EU, pulling the rest of it towards economic recovery.  But is that really true or does it just fit smoothly into the Weltanschauung of those who had been campaigning all their lives for structural reforms and a liberalisation of labour markets? The truth is that because of the size of Germany’s economy its large trade surpluses are counterproductive and indeed highly problematic for euro members with trade deficits. Not only does Germany continue to win market shares within the euro area, thereby undermining its own argument that other countries need to improve their competitiveness; large trade surpluses of a massive economy such as Germany’s also cause appreciative pressures on the value of the euro. Deficit countries, however, need exactly the contrary to export more of their goods. What they need is a devaluation of the euro so their products are cheaper on markets outside the monetary union.

But there is one further, even deeper concern why this obsession with chasing Germany’s competitiveness will lead the euro area into a Japanese-style deflation, likely to shape Europe’s economy for decades to come. And the core of that is the way how current governments envisage improving their competitiveness: through lower wages. Remember that Manuel Valls too mentioned reducing labour costs as key to his government’s strategy. And an analysis of what has made Germany so competitive shows it was not primarily the quality of its cars – although undoubtedly high – but rather a result of its impressively low unit labour costs. Unit labour costs are composed of the wage costs per unit in relation to productivity. They are so important because they have a huge impact on the price level and hence on inflation. Before the crisis, Germany and Austria were the only countries in the euro area in which unit labour costs had been rising below the ECB’s inflation target of 2%, thereby allowing real wages to fall and profit margins to increase. In other words: German products simply outprized those of its European partners. The belief that other euro members can now do the same – all at the same time – is, well…funny. Or it would be funny if it wasn’t so incredibly dangerous. With all euro members now trying to gain competitiveness by reducing labour costs, who will be left to buy all these goods? With downward wage pressures across the continent who will be able to buy anything at all, regardless whether domestic or imported products? Sure, as wages decrease so do prizes but one doesn’t need a degree in economics to understand that this marks the beginning of a full-scale deflation (we can observe deflationary signs already in countries like Greece and Spain).

To be sure, some European countries did have unsustainably high unit labour costs and they do need to bring them down if we really want to eradicate imbalances. France, however, does not belong to that group; in fact France was the only country in the euro area in which unit labour costs had been rising in line with the 2% inflation target set by the ECB. More importantly, if we want to fight imbalances based not upon deflationary and contractionary policies but on growth, it should be Germany taking the lion’s share of this adjustment process. That means that unit labour costs in Germany must rise significantly faster than in countries with trade deficits, thereby allowing the latter to take back market shares which Germany had won primarily with aggressive downward wage policies. There are signs of improvement though, with unit labour costs indeed rising faster in Germany than elsewhere in 2013. But the Commission rightly pointed out that this is far too cautious given the mere scale of market shares Germany had secured over a decade of low wage driven competitiveness. And it is only as of 2015 that Germany will join the club of countries with a minimum wage (€8.50 [£6.70]), a concession Angela Merkel has made to her social democratic coalition partner. These developments give hope that a European decade of deflation, stagnation and high unemployment may be averted after all. But as long as politicians like Valls, Hollande, Renzi or, for that matter, German social democrats continue to believe that the ‘German model’ would work for all countries at the same time, this hope will not materialise. Instead, what lies ahead is what Japanese call Ushinawareta Jūnen – the Lost Decade.