A shortfall in exportable supply
The troubled eurozone countries including Greece, Portugal, Ireland, Spain and Italy owe their problems to their external deficit, not to their fiscal deficit. The current-account deficit, which is still as high as 8 percent of gross domestic product in Greece and Portugal, was close to this level in Spain and Ireland at the time of the outbreak of the crisis. It was when the savers in the other countries refused to lend them any more that the crisis broke out ― and this can happen even in a currency area.
When the external deficit persists and non-resident lenders are no longer present, a serious balance of payments crisis breaks out, leading to a sharp rise in interest rates. This is what happened from 2009 and above all in the spring of 2011 in the eurozone, in the same way as it happened in South Korea, in Thailand, Brazil in 1998, and Turkey in 2000.
In the short term, Europe has found solutions to prevent the countries affected by this balance of payments crisis from defaulting: for Greece, Portugal and Ireland, loans granted by the European Union, directly or via the EFSF, and by the IMF; for Spain and Italy, funding of government bond purchases by the banks in these countries through the ECB’s introduction of long-term repos, which in this way finance the countries’ fiscal deficit as well as their external deficit.
But how can the eurozone crisis be solved for good? Solidarity between the member countries is weak and the eurozone is not a federal union. For example, there are no government transfer payments between the countries that would offset their external deficits; there is no possibility of devaluing like all the emerging countries mentioned above did in the past to restore the external equilibrium. To restore the external solvency of the troubled countries to wipe out their current-account deficit, a reduction in domestic demand can also be used, which would reduce imports and reduce the trade deficit.
But this method is unacceptable socially and politically, as it would inevitably lead to a huge rise in the unemployment rate, which is already 24 percent in Spain and 20 percent in Greece. In this configuration with a balance of payments crisis in a currency area without federalism and with a rejection of mass unemployment, the only remaining solution is to increase the supply of exportable goods and services in the troubled countries.
This can be done in several ways, according to the situation of each country:
Either through structural measures aimed at increasing the production factors that are required to increase exportable supply: education drive to improve labour skills (which is needed in Portugal, Greece and Spain); tax incentives to develop long-term savings and the financing of productive capital in these countries, where capital intensity is 20 to 50 percent lower than in Germany.
Or through reforms of the goods and labour markets like those currently being implemented by Mario Monti’s government in Italy: reduction in redundancy costs and in the number of job contracts, incentive to return to the labour market and opening up of closed professions.
But an increase in production factors and structural reforms have effects only in the long term; unfortunately, the only solution to increase the supply of exportable goods and services in the short term is to reduce labour costs, which can already be seen in Ireland, Spain and Portugal, with the expected beneficial effects in terms of demand and employment. Even though the objective is not to reduce demand and imports, but to increase supply and exports, the initial effect on unemployment is negative.