“Greece and perhaps Portugal need to exit the euro at some point” – Michael Spence
Michael Spence is a world authority on growth in developing countries and on the convergence between advanced and developing economies. He received the Nobel Prize in Economic Sciences in 2001 for his contributions to the analysis of markets with asymmetric information.
Spence is a professor of economics at the Stern School of Business at New York University, Professor Emeritus of Management in the Graduate School of Business at Stanford University, a Senior Fellow of the Hoover Institution at Stanford and a Distinguished Visiting Fellow of the Council on Foreign Relations. He has also served as the Dean of the Faculty of Arts and Sciences at Harvard and the Dean of the Stanford Business School.
His most recent publication is The Next Convergence: The Future of Economic Growth in a Multispeed World (May 2011).
Europe has adopted austerity as the main path to economic stabilization and recovery. However, it appears that until a credible ‘European Plan’ that effectively backstops the euro zone’s weakest economies is finally adopted, we will continue to see how highly indebted countries with unsustainable current account deficits will merely struggle to maintain access to credit markets. What are your thoughts on alternative, missing or additional strategies for such a ‘European Plan’ to be completed?
Well it is a hard problem.
My view is roughly as follows: Greece and perhaps Portugal need to exit the euro at some point. The reason is that the productivity deficits are so large that even without a fiscal challenge their growth potential is limited, and with a fiscal problem, it is hard to imagine austerity combined with that much deflation working politically and socially. There are signs that Greece is already having extreme difficulty with the reforms.
Italy and Spain are in a different category. Reforms with stabilize them and restore growth. It will not be easy but it is manageable and the process is under way in both countries. Ideally the EU and the ECB would backstop these efforts with a program to stabilize the yields on sovereign debt in these two countries to give the reforms time to work. The problems are: (1) the Germans went through a difficult reform process and think others should too, and (2) the policy makers in and around the ECB don’t trust the politicians even if they believe the reformers. This is a moral hazard problem. What I think, and hope, is that this kind of intervention will be forthcoming even if they won’t say it unambiguously, the latter to keep up the pressure on the political systems to support the reform programs.
Meanwhile, Germany is insisting that institutional reform toward greater fiscal discipline and centralization go on in parallel. Again the reason is that they and others feel that if the crisis ends first, then the incentive for reform will go away, and the pattern could repeat itself down the road.
So we are going to do both. Reform for fiscal stability and growth in a number of countries with unannounced support from the center as needed, and, at the same time, fiscal centralization of some kind. The latter is needed. Some might disagree about the timing.
Some argue that precious time has been wasted in the handling of Greece, and that a ‘controlled default’ back in 2010 would have set the Greek economy in the path to recovery much sooner. What are your comments on this? In your opinion, is continued euro zone membership still an option – or even desirable – for the Greek people?
Yes and no.
Yes it would have been better to tackle a semi orderly default and withdrawal from the euro sooner for Greece, despite the fear of unanticipated consequences and a cascading problem in the euro area more generally. And no at this point, for Greece, I think that resetting the terms of trade is better than the alternatives. Even then, they would still have to get the fiscal dynamics in order and try for reforms to enhance productivity and growth. It would just be a less deep a hole to dig out of.
Despite increased talk of euro zone breakup, the subject remains anathema and French President Nicolas Sarkozy has recently gone as far as implying that such a scenario would endanger peace in the continent. What do you think of the idea of dividing the euro zone into two monetary areas in order to avoid a total breakup while maintaining some sort of coherent European market?
I don’t think the euro zone core or unity and peace in Europe is threatened by the departure of the smaller players from the euro zone, though there are risks as there is no pre-built mechanism. Italy and Spain can and need to succeed and stay in. So I don’t really buy the two speeds, two currencies model. I think it is the euro zone core working with a few departures.
The countries that grew by leverage, private or public, and there are a lot of them including the USA, need to adopt a more sustainable growth path, without a larger currency unit or on their own.
Much is made of Germany benefiting from an undervalued currency, but most forget that difficult German reforms were carried out in Germany in the period 2000-2006, and those dramatically enhanced productivity, flexibility and competitiveness. So Germany didn’t just end up there by accident. In 2000, Germany had a large self-identified problem in these dimensions, and went after it the right way, and aggressively, unlike many of their neighbors.
Having said that, it is in Germany’s interest to have the euro zone and the EU hold together and its leaders know and believe that. So then it becomes a choice of strategy to get there.
But is it sound for a country such as Spain to engage in the same contractionary policies as those of Greece and Portugal? Aren’t news headlines and market pressures dangerously driving us to ignore the idiosyncrasies and special needs of each troubled nation in Europe?
I suspect that the fiscal austerity is needed to keep financing the government. Not all fiscal austerity is growth negative. It depends on what you cut. Same for America. If you or we cut education, infrastructure, skills investments, etc., it will be growth negative. The problem is one of intertemporal choice. We have all been living beyond our means. We can try to hold on, but only at the expense of the future and future generations. Or we can pay for it now.
Having said that, cutting deficits is fine, but you can cut them too fast. Spain and other economies are adjusting structurally and that takes time. The time path of deficit reduction needs to be matched to the structural adjustment as much as possible. Otherwise the economy will suffer a massive reduction in aggregate demand – and that is negative for growth and via the growth route, for fiscal stabilization as well.
And why is it that Italy, which has been implementing austerity and structural reforms for some time, has been subjected to higher market pressure than Spain?
Italy is wealthier because of very high savings rates over long periods of time. There are lots of problems, public debt at 120% of GDP, tax evasion, rigidities in labor markets, other elements of non-competition, etc. But the main reason for the loss of market confidence until recently was concern about a distracted dysfunctional government. In other words, investors doubted that a vigorous policy response would be forthcoming. Now they are more positive on that, but there are two scenarios (economists would say equilibria) and the bad one has the yields running up as private investors withdraw, making the fiscal problem go from manageable to hopeless.
In your latest book, The Next Convergence, you relate a diminishing asymmetry between emerging nations and advanced economies. How does this continuous leveling of the world’s economic field fare against protectionist resistance from the current growth slowdown in the high income countries?
The protectionism has been muted thus far. But persistent high unemployment and low growth could turn that to much higher protectionism. That would slow the growth of the emerging economies, probably substantially, but not stop it. They are more resilient now. It would be a much more volatile, less “cooperative” international economic environment. Not a good thing.
It seems clear that Europe’s aging population will eventually require it to ease immigration and labor movement laws – especially if it wishes to sustain its welfare system. How does demography play into the economic convergence phenomena you analyze?
Demography is important. I suspect you are right that more migration is likely. But there are political and social limits. So I expect that the main policy rebalancing is going to have to be internal, changing working lives, pension parameters and incentives and so on. That the principles of the welfare systems can stay, but the parameters that are affected by life expectancy have to shift. Welfare systems are going to have to be more funded and less pay as you go to accommodate the shifting and uncertain demographics. That can’t be done over night, to put it mildly, but over a decade and a half it can.
It is a big challenge. Aging is not ubiquitous, but close, including in China. So the rank order is Japan, much of Europe, the USA, and China. The more youthful areas are India, Latin America, though that will not last forever. Africa is young and some of the Middle East. That is a double edged sword. With high growth it is helpful; with low growth it is explosive, via the youth unemployment channel.
Bottom line, every country should plan with sensible migration parameters to put themselves closer to equilibrium on an intergenerational basis.
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