The Competitiveness Crisis

The real root of the euro crisis is the gap between Europe's core and periphery -- and it's getting wider.

The recent news from Europe could hardly be more unsettling for those who desperately wanted to believe that the eurozone was finally finding its way out of the region's imbroglio. The collapse of the Dutch coalition government over budget cuts dramatically called into question the commitment of the staunchest supporter of the German hard line on the need for fiscal austerity. On the same day, the National Front, whose platform calls for an exit from the euro, gained a record 18 percent of the vote in the first round of the French presidential elections. And the results confirmed François Hollande, who wants to renegotiate the European Union's recent German-inspired fiscal pact to create room for growth policies, as a firm favorite to wrest the presidency from Nicolas Sarkozy. Not surprisingly, markets retreated and troubled countries such as Italy, Spain, and France itself saw their borrowing costs soar.

Indeed, every time Italy and Spain -- two of the world's largest economies, with a combined government debt that exceeds $3.5 trillion -- struggle to refinance their debt at acceptable interest rates, the eurozone and the global economy flirt with disaster. Yet while the commotion over bond spreads is entirely justified, it diverts attention from the main arena where the survival of the euro will ultimately be decided: the realignment of Europe's peripheral economies (Greece, Ireland, Italy, Portugal, and Spain, or the "GIIPS") toward exports and import substitutes (think Spaniards buying fewer Japanese cars and more Spanish-made cars). Since domestic demand in the periphery is declining fast as finance dries up and budgets shrink, trade is the only hope for reigniting sustained growth in the region. Without growth, unemployment will keep rising from its extraordinarily high levels, political resistance to the monetary union will escalate, and it will become more and more difficult to service debts, with the very real risk that countries will be forced into default and -- possibly -- an exit from the euro.

Until recently, improved global economic conditions and large-scale liquidity injections by the European Central Bank (ECB) into European banks under its long-term refinancing operation (LTRO) program had reassured markets and kept Italian and Spanish bond yields well below their terrifying peak of last November. Global conditions can change quickly, however, and the policies adopted, however necessary they may have been, are more palliative than cure.

For example, Greece's debt remains unsustainable, and a second round of restructuring -- this time to include forgiving official debt as well as private debt -- will be needed. And the ECB's LTROs, which have so far shored up banks and supported government bond purchases, may backfire if, as is already happening, risk aversion returns and the prices of government bonds that banks have acquired fall again. While the periphery cannot avoid cutting government deficits, it may ultimately have trouble hitting its deficit targets if austerity stunts growth.

More important still, it is vital to recognize that the periphery's fiscal mess is not at the root of the euro crisis. The crisis, in other words, cannot be resolved with a fiscal fix alone, although a fiscal correction must be part of the solution. For example, Ireland almost halved its debt-to-GDP ratio (from 48 percent to 25 percent) between 1999 and 2007 and Spain nearly did the same (62 percent to 36 percent). These ratios were much lower than Germany's at the outbreak of the current crisis and, in Spain's case, they still are. Nor are weak banking systems the cause of the crisis in the periphery. When the global financial crisis struck in 2008, for instance, the Italian and Portuguese banking systems were in much better shape than their British, French, or German counterparts. Fiscal and banking problems, dangerous as they are, are a consequence of the crisis -- not their primary cause.

Fundamentally, Europe's so-called debt crisis is really more of a competitiveness crisis -- one that divides the eurozone's core (Austria, Belgium, Germany, France, Finland, and the Netherlands) from its periphery. The misalignment began in the mid-1990s as interest rates in the periphery declined to the lower levels found in the core, and domestic demand and inflation grew more rapidly in the periphery than in the core. This, combined with highly inflexible labor markets and limited competition in sectors ranging from pharmacies to banks, led to an erosion of competitiveness in the periphery -- reflected in wages outpacing productivity and prices in the sheltered sector (comprising everything from government to construction to coffee and barber shops) rising relative to the prices of exports and import substitutes, whose prices are determined in world markets. There followed a progressive reallocation of the periphery's production capacity toward the sheltered sector, most visibly toward construction in countries such as Ireland and Spain, which went on to experience the mother of all housing bubbles. Measures and estimates of the competitive misalignment in the eurozone vary. Typical estimates suggest that, in the periphery, the cost of labor, adjusted for productivity, is higher by 15 to 30 percent relative to Germany.

This competitive misalignment had significant consequences. From 1997 to 2007, housing expenditure as a share of GDP cumulatively increased by 2.7 percentage points in the periphery (excluding Greece, for which data is not available prior to 2000), compared with a 2.2 percentage-point decline in Germany. Meanwhile, exports of goods and services as a share of GDP increased by almost 20 percentage points in Germany, compared with an increase of less than 3 percentage points, on average, in the periphery. In the periphery, current account deficits -- the excess of imports over exports -- deteriorated by nearly 8 percentage points of GDP. In the core, current account surpluses rose by 0.9 percentage points.

Financial markets mistakenly supported the periphery's domestic demand-based growth model, only to go into sharp reverse -- as they are wont to do -- when the model became patently unsustainable. Greece and Ireland, for example, experienced capital outflows equivalent to 40 percent and 70 percent of 2007 GDP, respectively, from mid-2008 to mid-2011. Current account deficits in peripheral economies did not narrow correspondingly because euros were made available through the intra-European payment system among central banks and rescue programs. Outside the eurozone, by contrast, countries such as Latvia (which did not devalue its currency) saw a huge and immediate correction in their current account deficits. The workings of the monetary union, in other words, have inhibited the eurozone's ability to narrow the very competitiveness gap that the monetary union helped create.

The external and internal imbalances in the periphery still necessitate a large competitive adjustment that can only occur through deflation, since adoption of the single currency means that devaluation is no longer an option. Given the post-2007 plunge in domestic demand in the periphery, one would have expected to see price and unit labor cost containment (either through lower wages or higher productivity) and a shift toward exports by now. But almost  three years after the euro crisis erupted, progress remains remarkably limited (see table). With the exception of Ireland, there has been little improvement in the competitiveness of the periphery (as measured by the decline in the real effective exchange rate, an indicator of labor cost adjusted for productivity and expressed in a common currency).

In fact, over the last year, the periphery has actually lost even more competitiveness relative to the core. These trends are reflected in the periphery's exports, which have hardly budged as a share of GDP, increasing by less than in Germany and the Netherlands. Italy's current account deficit has actually increased since the global financial crisis began. And while current account deficits have come down elsewhere in the periphery, this is largely due demand contraction, and the external deficits remain sizable (see chart). Greece is running a current account deficit that is 10 percent of GDP and showing no improvement in exports despite an 18 percent decline in domestic demand since 2007. Over the past year, the most notable changes that have occurred are further increases in the periphery's unemployment rate and (Italy excepted) government debt-to-GDP ratio.

More demand compression and recession are coming, and will place even more strain on the periphery's social fabric. Unemployment is excruciatingly high and headed in the wrong direction. The unemployment rate is already at around 24 percent in Spain, 21 percent in Greece, 15 percent in Portugal and Ireland, and 9.3 percent -- and rising fast -- in Italy.

With substantial fiscal contraction in store over the next two years, banks deleveraging, and consumers and investors scared, there is simply no possibility of growth from domestic demand in the periphery in the foreseeable future. Indeed, with structural reforms incomplete and slow to produce results, recession -- in containing wages and inflation -- is the main instrument to engineer the competitive realignment. And in economies where both the private and public sector have become highly externally indebted and competitiveness hasn't improved, any recovery of domestic demand will quickly run up against borrowing constraints as current account deficits widen.

In these dire circumstances, can the trade sector come to the rescue?

This currently appears least likely in Greece because its export sector is small and mostly based on tourism. Portugal has a bigger export sector, but one that still confronts Chinese competitors directly in sectors such as footwear and garments. Ireland, by contrast, has high-tech exports that amount to 100 percent of GDP and are funded and operated by foreign multinationals. For these reasons, Ireland has a chance of reigniting growth, but it may be hit again by large banking losses.

Spain, meanwhile, has several competitive international firms and, unlike the other peripheral countries, has maintained its share of European exports over the past decade. But its export sector is small at roughly 26 percent of GDP, its private sector is heavily and externally indebted, its unemployment is already extremely high, and its fiscal and housing sectors still require enormous adjustments. Spain's capacity to steer through more austerity is therefore questionable.

While Italy's public debt is larger than Spain's, it has a more diversified export base and smaller fiscal, housing, and labor market imbalances. Italy's austerity and liberalization measures, however, are still very recent, and there is no sign yet of a trade-led recovery.

How should Europe address these challenges? As many economists are advocating, a €2 trillion firewall could be erected to protect Italy and Spain, the ECB could provide unlimited support to governments, and eurozone governments could even jointly issue eurobonds that would be less liable to attack than those of individual countries. Yet even if the resolute German political resistance to these measures could conceivably be overcome in the event of a market panic, none of these approaches would deal with the underlying competitiveness issue, and could instead delay its resolution.

In any event, the political stars are not aligned at present for these ambitious steps and there is little alternative but to accelerate the adjustment process in the periphery through small steps. These could include tax changes that incentivize production and exports (such as cutting payroll taxes) and discourage consumption and imports (such as increasing value-added taxes), and more far-reaching labor and product market reforms such as reducing severance payments drastically and attacking price fixing with more determination. A less ideological approach to policy by Germany and less insistence on blanket austerity measures even in relatively healthy economies could also stoke demand in the eurozone's core, increase eurozone inflation, and lower the value of the euro, all of which would ease adjustment in the periphery.

If, however, all this and fiscal cuts are not enough to restore competitiveness in the periphery -- as has so far been the case -- and unemployment keeps climbing, new approaches must be considered. Should failing countries be assisted by healthier ones in the core, the ECB, and the IMF to restructure their debt and leave the eurozone? The complexity of doing so is daunting and great collateral damage would ensue, but there would at least be a light at the end of the tunnel. The alternative -- depression, chronic unemployment, deindustrialization, and depopulation of the afflicted countries, plus even more concentration of industry in northern Europe -- is not what anyone signed up for, or what electorates will accept.

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The Rubio Doctrine

The potential veep contender makes a decidedly non-Romneyesque statement on foreign policy.

The reason for the larger-than-normal swarm of live-tweeting journos and telephoto lenses packing the Brookings Institution's Falk Auditorium for Sen. Marco Rubio's foreign-policy speech on Wednesday, April 25, was, of course, the rampant speculation that the young rising star from Florida is on Mitt Romney's shortlist as a vice presidential nominee. But if those in the crowd were expecting Rubio to audition for the role of partisan attack dog, they likely came away disappointed. If anything, the primary target of the speech was not the president, but the increasingly isolationist rhetoric of some members of Rubio's own Republican Party. This included some digs at positions held by his potential running mate.

Billed as a "major" foreign-policy address (though as Time's Michael Crowley points out, you never seem to hear about "minor" foreign-policy addresses), the speech was a robust and full-throated defense of an activist U.S. foreign policy and the oft-evoked but somewhat nebulous concept of American "leadership" in the world. This is a bit surprising given Rubio's political pedigree. When the senator was elected to the U.S. Senate as part of the 2010 Republican sweep, he was generally associated with the Tea Party wing of the Republican Party and is still often referred to that way, though his relatively moderate views on immigration have alienated some former supporters.

In his foreign-policy views, though, Rubio seems to share more affinity with the neoconservatism of John McCain or even George W. Bush than the isolationism of fellow class of 2010 members like Kentucky's Rand Paul. He took aim at these tendencies right off the bat, noting that he believes he often has more in common with Democrats like Robert Casey and Robert Menendez, or independent Joe Lieberman -- who introduced him today -- than some Senate Republicans.

"I recently joked that today, in the U.S. Senate, on foreign policy, if you go far enough to the right, you wind up on the left," he said.

Rubio's foreign-policy views have evidently been recently shaped by a reading of Robert Kagan's The World America Made, a much-discussed refutation of the now-popular notion of American decline. He cited the author and Brookings scholar, who was sitting in the front row, repeatedly throughout the speech. (As a Romney advisor who has penned bedside reading for President Barack Obama, Kagan could plausibly claim to be the most prominently cited writer in Washington right now.) Rubio repeatedly echoed Kagan's arguments for the necessity of U.S. involvement in solving international crises.

In Syria, for example, Rubio supports "equipping the opposition with food, medicine, communications tools, and potentially weapons." This, he said, "will not only weaken Iran -- it will ultimately increase our ability to influence the political environment of a post-Assad Syria." He grumbled that his colleagues on the Senate Foreign Relations Committee seem "so concerned about the challenges of a post-Assad Syria that they have lost sight of the advantages of it." He also noted that "many of my loyal supporters were highly critical of my decision to call for a more active U.S. role in Libya."

At times, Rubio's speech could have served as a critique of the Romney campaign's foreign-policy statements. Whereas the inevitable Republican nominee has suggested that "it doesn't make a lot of sense for us to borrow money from the Chinese to go give to another country for humanitarian aid," Rubio defended the utility of aid, saying, "In every region of the world, we should always search for ways to use U.S. aid and humanitarian assistance to strengthen our influence" and cited the Bush administration's work on AIDS in Africa as an example.

Whereas Romney's rhetoric on Iran has mocked the Obama administration's "charm offensive" and called for "crippling" sanctions on the "suicidal regime," Rubio argued, "We should be open to negotiations with Iran," though not be satisfied if they "only lead to further negotiations."

As the son of Cuban immigrants with a long-standing interest in Latin America policy, Rubio often seems most comfortable discussing the Western Hemisphere, and indeed his speech was accompanied by an op-ed in April 25's Los Angeles Times on Latin America policy. In it, he argues for putting a higher priority on Latin America in U.S. foreign policy, and, most likely referring to China, he claims that the biggest threat to U.S. interests in the region is not the overt anti-Americanism of Hugo Chávez and his ilk but, as he said in his speech, "the efforts of some nations to replace our influence with their influence and to use protectionism and other unfair practices to pursue that aim."

Perhaps having read his Amy Myers Jaffe, Rubio argues that increasing energy cooperation in the Americas could help lower U.S. reliance on the Middle East and "create countless jobs for Americans and energy security for the world." In his speech, he also brought up the somewhat controversial notion that Iranian-backed Islamist groups are making inroads in Latin America.

But Rubio's approach is hardly the blunt, partisan approach of his fellow Floridian, Rep. Ileana Ros-Lehtinen. Although he expressed skepticism about the "reset" policy with Russia and suggested that the Obama team places too much importance on the U.N. Security Council and international resolutions, his speech was strikingly nonpartisan. The only time Rubio even mentioned Obama's name was to praise him for continuing Bush's work on AIDS in Africa.

In other words, if this was an audition for a VP slot, it was an unusual one. A Rubio pick would certainly bring up some uncomfortable questions for Romney about the contradictions between their platforms.

It's possible that with foreign policy likely to take on greater importance in the general election if and as the economy improves, Rubio may be making the case that he can attract moderate voters turned off by the often-bellicose rhetoric of the Republican primary. Given, however, Americans' increasing skepticism about U.S. military engagements in Afghanistan and elsewhere -- a topic Rubio touched on only briefly and vaguely in the Q&A session following the talk -- it's not clear how much of a sell national-greatness conservatism will be this time around.

It also seems possible that Rubio is merely taking advantage of his 15 minutes in the spotlight to bolster his credentials as a credible voice on foreign policy. With Republican foreign-policy elder statesmen like McCain, Richard Lugar, and, for all intents and purposes, Lieberman nearing the end of their political careers, Rubio may be vying for their type of influence within the party.

If one judges only from this speech, it also seems pretty apparent that Rubio is less interested in padding Romney's 2012 ticket than leading his own in 2016.

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