Looking for a new day dawning on the European periphery
Barring a Grexit or “Graccident,” this year could be the one in which the Eurozone finally achieves escape velocity from crisis. The weaker euro, low oil prices, a German growth juggernaut - all should contribute to the needed boost. However, alongside the political and deflationary risks, there are potential blemishes on this rosy picture.
The latest Eurozone economic indicators reflect the promising environment and prompted us two weeks ago to raise our growth forecasts for the year. We now expect growth of 1.6% on average, up from 1.2%. It could even accelerate to 2% next year. But let’s not get too far ahead of ourselves. We need to acknowledge that, in the past five years, the region has had a tendency to fool economists by overpromising and underdelivering. We were always viewing the Eurozone in a warm fuzzy light at the beginning of the year, only to have to systematically lower our forecasts as it unfolded.
Another problem is that the growth outlook is not uniform. Germany as the engine of the Eurozone should fare well, expanding at a 2%-plus rate. Spain and Ireland, the latter likely to repeat as the European growth champion, will easily outperform the Eurozone as a whole. Portugal will roughly match it while Italy and France are poised to again disappoint. Finally Greece’s political situation is too confusing to permit any kind of meaningful forecast.
With regard to Spain and Ireland, one might conclude that the worst of the euro crisis is over and that those who advocated for radical reform and austerity have been proved right. But is this analysis true? After seven lean years is a new day finally dawning for the periphery? The answer is likely more complex than a plain yes or no.
Some reforms are likely helping, but unexplained factors remain. Putting the special case of Greece aside, we can see a clear divergence between high-growth countries like Spain and Ireland and medium to low-growth countries like Portugal and Italy. Italy’s underperformance (like that of France, which is not even on the periphery) can be partly attributed to a failure to reform. Let’s take unit labor costs (ULC) as a rough measure of “reform.” Relative to Germany’s, those of Ireland and Spain/Portugal fell by 10% and 13% respectively between 2009 and 2014, but those of Italy only 4% and France 2%, according to OECD figures.
However, taking the same metric and comparing 2014 with 1999, when the euro was introduced, the ULCs of all the countries under review have increased relative to Germany’s. Italy’s have risen most (21%), which again explains why the country is still suffering lackluster growth compared to the European core. The increases for Ireland (17%) and Spain (11%) are lower, though in the former’s case not enough to explain its large growth gap with Italy. The most striking number is Portugal’s. Compared to 1999, its ULCs have outpaced Germany’s by only 2%. Yet it markedly lags Spain and Ireland in growth performance.
In my view, reforms alone, or the lack thereof, cannot fully explain why some peripheral countries fare better than others. It pays to look at why the countries became entrenched in the euro crisis to begin with. For Ireland and Spain it was the conjunction of rising ULCs (which reduced competitiveness) with a housing and credit bubble caused by too-low interest rates. In Portugal’s and Italy’s case it was only the ULC factor. This is also why Ireland and Spain were labeled “Celtic” and “Iberian” tigers during their bubble heydays. Portugal and Italy, on the other hand, never really have profited from the euro. Both countries still have a real GDP at or even below where it was in 2000, meaning that they haven’t grown in the last 15 years. By comparison, even after deep recessions, Spanish GDP today is 21% higher than in 2000 and Irish GDP 37 % more.
It seems that the reforms have addressed the most pressing issues facing the peripheral countries and enabled them to finally reemerge from the euro crisis. However, in my view, they haven’t addressed the more fundamental issues. It appears to be same old, same old with Spain and Ireland speeding up again as Portugal and Italy continue to apply the brakes.