Krugman (2012(1)) has stated that the current crisis is “a balance of payments problem, in which capital flooded south after the creation of the euro, leading to overvaluation in southern Europe”. Dadush and Wyne have argued that at the root of the current crisis lies severe misalignment of real effective exchange rates in the Eurozone. In the public discourse one can also frequently come across a simplified explanation of the roots of the current crisis, which tells you that the current account surplus of Germany has largely been achieved at the expense of southern Europe*, where countries have lost competitiveness due to inability to devalue their currencies.
Some authors have also been quick to prescribe medicine to the Eurozone based on the above diagnosis. Krugman (2012(1)) has suggested that “non-GIPSI European leaders should realize that what the GIPSIs really need is a general European reflation” and a way to correct the imbalances would be for Germany to accept inflation above 2% (say 4%) for several years while southern Europe would have zero inflation. According to him, “we need a real devaluation in Spain mainly via German inflation rather than Spanish deflation. 4 percent German inflation plus zero in Spain might work; 2 and minus 2 can’t” (Krugman, 2012(2)). Darvas has also suggested that unit labor cost increases in the “core” countries would be one way to achieve internal adjustment. Dadush and Wyne mention that higher Eurozone inflation would ease adjustment in the periphery. The logic goes that this would help southern European countries regain competitiveness and bring their current accounts back to balance while the übercompetitiveness of Germany would be reduced and along with it its trade surplus.
Indeed, while Germany has been running a large current account surplus, such countries as Spain, Portugal and Greece and to a lesser extent Italy have been living with current account deficits for many years, the flip side of the coin being that the deficits have been financed by borrowing from abroad. Thus the southern European countries have been accumulating more and more foreign debt, both public and private or, in other words, their net international investment positions have deteriorated. However, this does not tell the whole story. Let us look at how the competitiveness of Germany and southern European countries evolved during last decade by examining the development of their market shares in global merchandise exports since 2000.
The market share of Germany in global exports in 2011 was about 8.2%, only slightly down from 8.6% in 2000. At the same time Italy’s market share has gone from 3.8% in 2000 to 4.0% in 2003 to 2.9% in 2011. However, Germany has also been losing market share since 2003-2004 when it peaked at about 10% and a similar trend over last decade has been experienced by most other developed countries. The name of the biggest gainer is, of course, China, as can be seen in the chart below.
As the economies of China and such countries as Turkey and Russia have been growing faster than the economically advanced nations, it is only logical to expect the weight of the former in global trade to increase at the expense of the latter. Thus, if Germany is the only nation that has been able to keep its market share almost unchanged while those of other countries have gone down significantly, that might indeed give support for the argument that Germany is benefiting from an undervalued exchange rate. However, looking at a broader set of countries, a somewhat different picture emerges.
Both Switzerland and the Republic of Korea have shown even stronger merchandise export development than Germany while allowing their currencies to float. At the same time Sweden with a freely floating currency and Denmark with a band vis-à-vis the euro, both frequently celebrated as export champions, have seen their global market shares fall during last decade by about as much as Italy. It is true that this comparison over time ignores the fact that the ratio of exports to GDP in Sweden and Demark was much higher than in Italy back in 2000, however, since then Italy has done as well (or as badly) as Sweden and Denmark while the other southern European countries have done better in relative terms.
Finally, it could be possible that Germany has been able to keep its share of global exports almost constant by increasing its exports to southern Europe, in particular, its larger economies such as Italy and Spain. However, a look at the development of the market share of German merchandise exports into Italy, Spain, Portugal and Greece does not confirm this view either. As can be seen in the chart below, Germany has been losing market share in southern Europe during last decade.
Germany is not trading only with southern Europe. In fact, more than half of its foreign trade turnover is with countries outside the Eurozone. Three of its Top 5 and five of its Top 10 trading partners are not members of the euro zone and the large weight of the Netherlands in its trade turnover is partly explained by the port of Rotterdam being a significant transportation hub for German imports and exports.
What can we conclude from the above analysis of merchandise export market shares? While the role of capital inflows in sustaining the current account deficits in southern Europe is obvious and Spain, Portugal, Greece and even Italy had relatively low ratios of exports to GDP at the advent of the euro, it is wrong to say both that the export sectors of southern European countries have experienced a huge loss of competitiveness during last decade and that this has happened as a result of their inability to devalue. In fact, the loss of global export market shares by southern European countries since 2000 has been comparable with that experienced by large developed trading nations while changes in market shares over a longer period of time are not correlated with the currency regime chosen by a country (Aghion and Durlauf).
The above also means that the cure suggested for the Eurozone in the form of higher inflation in the “core” countries might actually rather turn out to be poison. For example, what would be the result of German ULC going up significantly? That would inevitably result in loss of competitiveness and market share in global exports. However, the German market share in global exports is 8.2% while the combined market share of Italy and Spain is about 4.6%. Given the relatively lower weight of southern Europe in the global exports, the gains in competitiveness by Italy and Spain as a result of zero inflation there are unlikely to be big enough to offset the losses by Germany. Thus, not only Germany, but the Eurozone as a whole would be worse off as a result.
A fundamental problem for the Eurozone is that its institutions lack credibility, and higher inflation will further reduce credibility without contributing to long-run growth. The original rules of the Eurozone stated that member countries were not responsible for the debts of other members. Explicit limits were imposed on the size of budget deficits and debt ratios. The European Central Bank was assigned an inflation goal that would dominate all other goals. The nature of Eurozone membership has changed dramatically as nearly all these rules have been broken. Members are increasingly responsible for the debts of others. Most members violate the budget deficit and debt limits with impunity. Now if higher inflation is imposed on the European Central Bank, all the original rules will have been violated. The rule of law would be replaced by an awkward and unpredictable policy of „making up the rules as one goes along”. Any future promises or commitments by Eurozone institutions would have little credibility with the public as a result. Furthermore, once inflation gets anticipated, it is difficult to lower inflation expectations without a severe reduction in real output and employment.
The export sectors in Italy, Spain, Portugal and Greece might indeed be relatively small for them alone to bring the countries back onto growth path. We agree that a part of the solution could be tax changes in the southern European countries that incentivize exports and discourage consumption and imports, and more far-reaching labor and product market reforms as proposed by Dadush and Wyne. Similar ideas have been proposed by Gopinath et al. as well as Keen and de Mooij. A combination of privatization of state assets and debt restructuring is also an option for southern Europe to bring the public debt to GDP ratios down to a level that does not hamper growth (see Caner et al.). Reducing the competitiveness of Germany and resorting to inflation should not be a part of the solution.
\For the purpose of this analysis southern Europe refers to Greece, Italy, Portugal and Spain*
Aghion, Philippe and Stephen Durlauf, eds., “Handbook of Economic Growth”, Elsevier, 2005.
Caner, Mehmet, Thomas Grennes and Fritzi Koehler-Geib, “Finding the Tipping Point – When Sovereign Debt Turns Bad”, The World Bank, July 2010.
Dadush, Uri and Zaahira Wyne, “Is the euro rescue succeeding? An update”, VoxEU.org, April 20, 2012
Darvas, Zsolt, “Internal adjustment of the real exchange rate: Does it work?”, VoxEU.org, July 6, 2012
Gopinath, Gita, Emmanuel Farhi and Oleg Itskhoki, “A Devaluation Option for Southern Europe”, Project Syndicate, March 1, 2012
Keen, Michael and Ruud de Mooij, “Fiscal devaluation as a cure for Eurozone ills – Could it work?”, VoxEU.org, April 6, 2012
Krugman, Paul (2012), “European Crisis Realities”, New York Times, February 25, 2012
Krugman, Paul (2012), “The Breakeven Point (Wonkish But Terrifying)”, New York Times, June 1,2012