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Leaders in their respective countries may not be happy about it, but the acronym “PIIGS” by currency traders to reference Portugal, Ireland, Italy, Greece, and Spain will be with them for a long time. The five countries did not all make their way into the acronym for identical reasons but shared a sovereign debt load that many have seen as unsustainable. Underlying the vulnerability is the use of the Euro. The common currency prevents any one country from using monetary policy as a tool to confront high debt loads and equilibrate wages and prices in different countries when they become out of line. With steadily building confidence in Europe and better economic data, the fortunes of the PIIGS have improved, but no one is out of the woods entirely yet.

The Eurozone crisis that first fully exploded in 2010 was only partly caused by irresponsible government spending in the years leading up to it. Of the PIIGS nations, only Italy and Greece had unsustainable debt to GDP ratios before the financial crisis. The largest factor in the Euro crisis was current account deficits in the southern, periphery countries in Europe. A countries’ current account deficit represents the gap between investment and savings in the country, as the capital account and current account must sum to zero. Portugal, Ireland, Spain, and Greece all saw substantial capital flowing into their countries as real estate markets boomed, with the offsetting impact of higher current account deficits in those countries. Greece and Italy also both spent irresponsibly, reducing national savings available for investment.

Current account deficit, 2006-2017 for PIIGS nations and Germany.

While the real estate boom and accompanying capital flows into these countries persisted, investment and construction employment masked how uncompetitive workers in the southern countries were becoming versus their northern counterparts, particularly in Germany.

When one nation becomes uncompetitive with another, either productivity must rise or wages must fall in the uncompetitive nation to restore a balance. This is typically done by adjustments in foreign exchange rates. A weaker currency in the uncompetitive nation reduces their wages in the other countries currency and restores balance. Obviously, this cannot happen when the two countries use the same currency. Barring a sudden spurt of productivity growth, wages have to fall in the uncompetitive country relative to wages in the other country.

Unit labor costs in PIIGS nations and Germany, cumulative change 2006-2016.

Relatively falling wages have been taking place throughout southern Europe since 2008-2009, except for Italy, who has seen its unit labor costs continue rising faster than Germany’s. Why? That is something of a puzzle, but many economists have attributed the gap to how the numbers themselves are tabulated. Italy is rich in tech and fashion jobs and as jobs in those industries gain versus other jobs, the unit labor costs in the country are more an indication of the mix of jobs in Italy instead of how costs in similar jobs are changing over time.

Italy aside, what had to happen in the peripheral countries, a revaluation of unit labor costs versus northern Eurozone countries like Germany, has taken place, but it has been extremely painful. The sovereign debt crisis only exacerbated matters. It was not social welfare programs in Europe that drove up debt prior to the financial crisis. In almost all cases (again Greece and to some extent Italy are the outliers here) Government debt was the result of the need to rescue the financial system in 2008.

Government debt to GDP, 2006-2016.

Falling wages and enormous debt burdens can make for a disastrous situation and place countries on a treadmill they cannot walk off. In the case of Ireland, whose fundamental problem was a financial sector that was too large for its economy, the country has basically recovered fully, is competitive with other Eurozone members, and has debt levels back in balance. Portugal and Spain have also turned the corner. Government debt is no longer rising and their economies are growing again. That leaves Italy and Greece. The two countries have stabilized their growth numbers, although Italy remains in desperate need of fiscal consolidation and Greece’s ability to repay its foreign debt remains unlikely today as it did at the height of the crisis.

Real GDP growth, 2006-2017 (estimated).

The shocks to the Eurozone that caused the crisis were not pre-ordained, nevertheless, it’s foolish to not think that dislocations will naturally occur over time. The important question in assessing whether the Euro was good is whether the added convenience of doing business across borders outweighs the non-optimal monetary policy forced on many European countries. Based upon the pain that’s been experienced, it probably is not. But, the recovery in much of the periphery and pro-European Governments in France and Germany means that for now, Europe is going to get more time to work through its economic and political experiment.

 

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