Monday, September 21, 2009

Spain and Estonia: More evidence of a vicious circle

In Germany exports its disease dated September 3, I argued that during the next decade the peripheral countries in the Eurozone are likely to suffer Germany's economic fate. While Germany earlier this decade was caught in a vicious circle (low inflation=high real yields=low growth=low inflation), the bust of the previous housing and consumption boom in countries such as Spain and Ireland is threatening to hold back economic growth for a protracted period of time. Inflation in Spain and Ireland for the first time since the existence of the Eurozone has dropped significantly below German inflation and therefore real yields in Spain and Ireland have risen above Germany's. This in turn, will hold back Spanish growth relative to Germany. However, it is not only the inflation/real yield linkage which renders low growth self-reinforcing in the currency union.
Additionally, low growth constitutes a strain on public coffers and in turn, the budgetary situation deteriorates. Even though the 3% deficit limit according to the Maastricht Treaty has in practice not been adhered to strictly, it still serves as a soft limit. In turn, the underperforming economies are forced to conduct a tighter/less easy fiscal policy than the outperforming economies, again strenghtening the economic vicious circle. This article in El Pais dated 11 September states that the Spanish prime minister Zapatero is planning to plug the rising budget deficit with new taxes, possibly an increase in VAT, and other consumption tax to help close the gap of the country’s fast expanding budget deficit. There are no details available yet but it is thought a VAT increase could raise approx. 1.5% of GDP. This alone would constitute a significant fiscal tightening, adding to the economic difficulties of Spain.
However, this vicious circle is not only apparent within the Eurozone, it is also happening in EU member countries who would like to join the Euro. This article in the Telegraph from today entitled Debt deflation laboratory of the Baltics suggests that the Baltics and especially Estonia are exhibiting the same dynamics (but on an even larger scale). To quote: "Estonia's euro peg is anything but free-market. It makes Tallinn dance, awkwardly, to Frankfurt's distant tune. It stoked the boom by enticing people to borrow cheap at eurozone rates: it is now prolonging the bust....Most governments would try to cushion the blow. Estonia is instead pushing through yet another austerity package to keep the budget deficit below the EMU ceiling of 3pc of GDP. Such is the totemic appeal of euro entry in 2011."
While the article makes the case for a devaluation vs. the Euro, this would be difficult to achieve and might not help the situation. it could threaten the euro entry and additionally it would hurt the private sector as foreign debt totals 116% of GDP. But given the low indebtedness of the state (the article states that national debt stands at 5% of GDP), a temporarily large budget deficit could indeed be part of the solution.
Still, what the case of Germany over the past decade and currently Spain and Estonia are showing is that in a currency union (or a de-facto currency union such as with Estonia) without a fiscal union, economic weakness carries self-perpetuating traits via low inflation/high real yields and via the pressures for fiscal tightening amid rising budget deficits. This is not new but what it means is that it will take a very long time to cure the economic imbalances and with that puts more pressure on the government to conduct structural reforms to improve the economic situation. A return to sustainable above-trend growth rates for any of the affected countries should not be expected over the next several years!

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