Cause and Effect in European Politics and Law

The Fiscal Pact Will not Solve the Problem with EU Competitiveness

Ralitsa Kovacheva, March 7, 2012

The Fiscal Pact serves for Germany`s relief. What the EU countries need is structural reforms, Dr Evgenii Kanev, an economist with the European Strategies and Policies Institute, believes. According to him, the debt crisis stems precisely from the differences of productivity and hence - of the competitiveness of different countries in the eurozone, and "budget deficits are the buffer of lacking competitiveness." How have we ended up in the current situation and what are the possible scenarios for resolving the crisis in the eurozone – here is what Dr Evgenii Kanev commented for euinside:

When the crisis hit, all major economic areas, especially the US and China actively used their monetary policies to manage the crisis, so it did not to "crush" their economies. China continued its policy of tied to the dollar yuan, that had started even before the crisis. It's like letting a lot of money in circulation, to make your currency cheaper and promote exports. China's model is to maintain its currency cheaper than the dollar in order to promote its exports to the US. America, on the contrary, printed dollars and a lot of money was poured into circulation to promote liquidity, and the interest rate fell below 1% to stimulate economic activity.

I give this example to make a comparison with the eurozone behaviour in the same time. The European Central Bank is "statutory" forbidden to print money beyond some indicators which monitor economic activity. Limited money supply is pressing the euro area economies, because they cannot use the printing of money to promote economic activity, especially in terms of exports.

On the other hand, in the euro area we have fundamentally different economies. Usually, in such a situation the currency of a more productive economy is rising compared to that of a weaker one, as currency is also a reflection of productivity - the greater the productivity of an economy, the stronger its currency in equal circumstances. What do we have, however: Germany, which has made structural reforms in the early 21st century; has prepared itself extremely well for globalisation and has increased significantly its productivity. This is reflected in the very economic structure, in the products it produces and in the increased exports.

However, other states, mostly in the southern periphery, have not done the same. Therefore, assuming for a moment that Germany had the Deutsch mark, and the Greeks had the drachma, it would have resulted in a sharp devaluation of the drachma against the Deutsch mark. However, when there is no such possibility of devaluation, then there are three classic cases of behaviour of euro area economies, including countries like Bulgaria, with a currency board and a currency pegged to the euro. The first case is the best one - these are high-performance economies, Germany and the Nordic countries. They are not largely affected by the strong currency, because their products have high added value, where the cost factor is not the most important one. For example, even if there is a global cataclysm a BMW will hardly ever be sold for 10,000 euros. Despite the strong euro, German exports have grown rapidly, precisely because they have an exclusive place in the global economy.

The other economies, however, in "the wider euro area" (together with countries with currency boards), do not have such products and such a performance, so they compete on a cost basis. The Southern periphery, for example, produces exports of about 30% of GDP, precisely because the euro is too expensive for it, as it competes on low cost markets. Greece, for example, has six and a half times greater economy than Bulgaria but the same exports level - below 19% of its GDP. Portugal`s exports is below 25% of GDP, Italy`s is also about 25%. For comparison – Estonia`s exports amounts to 90% of GDP, Belgium`s 85%, Ireland`s 90% - all Nordic countries have exports over 50-60% of GDP. The example of Greece shows that when you rely only on one foot (domestic consumption), your default is very likely if something is changed in the macroeconomic situation.

When you compete on price, you must cut costs in order to increase competitiveness – the manufacturers lower their margins, cut labour costs, including directly dismissing people. This way you release the steam to promote exports. But unlike Bulgaria, where we have a very low base for costs and wages, which makes us competitive, the same cannot not be applied in other countries for political reasons. You cannot dramatically cut costs, reduce wages, or bring out quickly competitive products. Structural reforms are needed, but they are also politically blocked. What happens then? Budgets create buffers for the lacking competitiveness. When economies collect relatively less taxes and have fixed costs, deficits appear. And they are financed by debt. Indebtedness is facilitated by cheap credits, since in the euro area all have the same risk – as the Germans can borrow on 3%, so the Greeks can.

Why I do not believe in the fiscal pact?

It is designed to support the euro. This is a classic case where we harness the economy to maintain the currency, instead of using the currency to boost the economy. It is designed to comfort Germany. However, to maintain this union, one of several things should happen - the southern countries to quickly make structural reforms, invent new products and services with high added value that make the economy more competitive, so that exports can grow at least to 30-35% of GDP; leave the eurozone to devalue their currencies; go the Bulgarian way and cut drastically salaries and pensions.

What will happen in 2012: The momentum of "we are united, we must make the fiscal pact at all cost" will continue. But there is one problem: the more you press the public sector, that has been a basic core bearing the whole economy, especially in Greece, the more the GDP shrinks. Accordingly, you have less taxes in the treasury and it is harder to keep the budget deficit. And to find money from somewhere, you need to raise taxes, there is no other way. And the more you raise them, the more you send away foreign investors and go into a spiral from which I do not see a way out.

Already at the discussion on EU economic governance, organised by euinside, I predicted that spending cuts would lead to nationalist unrest. And some will even try the scariest - to leave the euro area and to establish their own currencies, which will lead to even greater disaster, and then they would like to reintegrate again. But it is more likely they to remain in the EU and cut salaries and pensions. Governments will change, one will fall and a new one will come. But what tools does the new government have? The same. It cannot invent new products and services in one night or one year, structural reforms are necessary.