Macroeconomic Imbalances in Europe is the Problem

The core problem at the heart of Europe is a structural imbalance between export led economies with current account surpluses (Germany, Netherlands, Austria and Finland) and economies with current account deficits (Italy, Spain, Greece, Portugal and Ireland). This is a structural problem with deep historical roots. It has also contributed significantly to the current crisis. Countries are being encouraged to export their way out of the crisis. But, how realistic is this?

Think about it. Not every country can run a current account surplus. Not every country can adopt an export led economy. For every surplus there has to be a deficit. For every export there has to be an import. Trade is a relationship between a buyer and a seller. Europe, overall, has a strong current account surplus, given that the strongest export in the world is at its center – Germany. But, so much of what Germany sells is internal to the European market. They are the biggest beneficiaries. Yet, all of the focus has been on the deficit countries i.e. those who buy and import the exports of the stronger economies. Since 2000 Germany recorded a surplus of €192.2 billion whilst Ireland, Spain, Italy, Greece and Portugal recorded a combined deficit of €192.8 billion.

This structural imbalance is being swept under the carpet for normative not economic reasons. To argue that export led growth for all countries is not the solution, and that those countries with a huge surplus are a core part of the problem is totally alien to economic orthodoxy. But, if we are serious about solving the crisis, it must be put on the table for discussion. Ireland, of all the deficit countries is the only one that can turn a current account deficit into a surplus. That is because it has a relatively strong, capital-intensive, export economy premised on US investment. The rest of European deficit countries do not have this. To reduce their current account deficits and regain competitiveness, all are encouraged to bring down unit labour costs.

This point is crucial. The standard narrative of Europe’s crisis is as follows; the GIIPS countries lost competitiveness since 2000 because unit labour costs got out of control. This made their exports more expensive. Germany on the other hand, controlled unit labour costs and hence their exports increased. This narrative is based on a standard orthodox economic explanation of nominal and relative unit labour costs in the process of production and exchange. If the GIIPS want to get out of the crisis, all they have to do is bring down unit labour costs. This improvement in ‘competitiveness’ will kick-start an export led recovery.

The truth, of course, is much more complicated. A loss of ‘competitiveness’ due to labour costs is probably only true for Ireland. Most countries lost competitiveness, and ended up running a current account deficit simply because they imported more than they exported. Again, this common sense observation has been lost on much of the economic profession. Import demand outgrew exports by 7 percentage points in the GIIPS countries. The opposite occurred in Germany.  The GIIPS countries did not experience a competitiveness problem but a problem of excess domestic demand! People were buying too much stuff.

The rapid increase in imports overshadowed the stability of export market share in the GIIPS countries. Domestic economies in deficit countries began to overheat and prices became inflated. All of this is based on a lending and borrowing relationship. This is the source of the debt crisis in Europe. Liquidity dried up, financial markets panicked and sovereign states soon found it impossible to raise funds to pay for day to day expenditure. Greece was the first domino to fall, Germany stuck to a non-interventionist policy and the rest is history.

Tightening fiscal policy and holding down incomes in the GIIPS will depress domestic demand. It might lead these countries into current account surplus because imports will fall. But, it will not solve the problem of intra macroeconomic imbalances within Europe. If Germany wants to remain in the Eurozone it has to start using its surplus productively by ensuring, much like the USA, continued liquidity of the European market.


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