Can the Euro Survive Globalisation?

12 FEBRUARY 2014   CAN THE EURO SURVIVE GLOBALISATION?   PROFESSOR DOUGLAS MCWILLIAMS     Introduction   We are picking off specific problems now in the last two of my more serious Gresham lectures.  Today I deal with the Euro and Globalisation. Next month I will deal with domestic economic policy in the UK. My final lecture is not on economics as such but on a subject of much greater importance – cricket. The Delors Report in 1989 that set up Economic and Monetary Union for the Eurozone did not mention globalisation or the rise of China. Neither did the first official European plan for monetary union, the Werner Plan in 1970, and – though the document is not available on the internet for a word search – I think we can safely assume that the Schacht Plan drawn up by Hitler’s economic guru, which in many ways was the predecessor of the plan for the Euro, did not either. In retrospect this looks a huge omission.   This is because globalisation has proved to be a huge asymmetric shock to the Eurozone. An asymmetric shock is one of the things that has created real problems for fixed exchange zones because it is an economic shock affects the different parts differentially.   I will start by showing how Europe’s preference for the comfortable life and for cushioning people from some of the pressures of the real world has affected its competitiveness. This, in turn, has led to disappointing growth that has, at best, underperformed expectations and at worst, as in Italy, disappeared entirely. The Italian economy has shown less than zero net real growth for the entire thirteen-year period of the present century. It is the combination of slow growth and the growing cost of the public services that cushion the pressures of economic life that has caused government spending in Europe to get out of kilter as a share of GDP, which in turn has led to the Eurozone government debt crisis.   I will then look at the differential international trading performance between different Eurozone economies, using trade with China as an example. I will show how some countries in effect compete with the Chinese while others provide the goods that the Chinese very much want to buy. This means that globalisation has very divisive effects on the Eurozone, pressures that would normally be met by currency adjustment. The alternative is the painful step of internal devaluation which destroys consumer demand as it reduces wages.   Having shown how globalisation underpinned the major challenge to the Euro, I will then show how it has bailed the Euro out. We have done some interesting detective work on the role of the Chinese investment of their foreign currency holdings in Euros to bail out the stricken currency and its bonds after the crisis of 2010/11. While Outright Monetary Transactions were the signal for the change in sentiment, they have not actually had to be implemented (and it is now the case that there might be legal challenges if they ever did have to be implemented, based on last week’s ruling by the German Constitutional Count in Karlsruhe).   I will conclude by looking at the future of the Euro and also at whether the UK, which will allegedly have a referendum on staying in the EU, should do so.   Impact of globalisation on economic structure   Globalisation has changed the whole world economy. My case for claiming that it is the world’s greatest ever economic event is based not just on its pervasiveness – though anything affecting two thirds of the world’s population must be pretty pervasive – but also on its speed.  And because much of it has happened within the lifetime of a single individual, it means that for many in the emerging world they still have the attitudes of people who are used to poverty at a time when they have become prosperous. So they work harder, take fewer holidays and give far more importance to sustaining economic growth in their public policy and far less priority to cushioning economic discomfort than we do in the West. And although I am sure that this will eventually adjust, it is likely to do so much more slowly than would suit those of us facing their competition.   Competitiveness   The rise of the emerging economies resulting from globalisation has hit Europe’s competitiveness badly. In Europe we have tried hard to cushion many of the hard edges of economic life – we have social security, taxation (which is increasingly paid mainly by corporates and the rich) and heavy social regulation. As a result we work shorter hours than anyone else in the world and take longer holidays than anyone else in the world. Because taxes on employment are a major way of paying for the social policies in Europe, we also have the highest employment taxes in the world. We also have the earliest retirement ages in the world and the highest age for starting work in the world, which means that many European countries have a remarkably short working lifetime. Meanwhile, the emerging economies are competing not just on cheap labour but increasingly on a combination of (admittedly not quite so cheap but still low) labour costs and increased productive capacity. To take the example of China, as it moves up the technical ladder, it is massively expanding the product range where it competes against the European economies. According to the Complementary Index for European and Chinese Exports, an economic indicator measuring relative competitiveness, the EU is now (2012) in direct competition with China on 35 percent of the 5,775 types of goods traded, compared with 15 percent in 2000 .   Let me divert here to deal with a red herring that is sometimes raised at this point, often by sloppy journalists. I am most emphatically not saying that people in Europe should work longer hours or take shorter holidays. The hours that people work should be their own decision, unless they work in a sector where long hours impose risks on the general public.  The decisions people make over hours and salary are a trade-off and when a new economic factor like globalisation appears, this trade-off changes. Because we are competing with people who essentially have a different economic model from us – and are likely to remain with this different model for some time to come – we need to factor this in to the decisions that we make when we trade hours worked for income.   Where things get distorted in Europe is when the costs of shorter hours or not working at all are paid for not by the person making the decision whether or not to work or for how long to work but by other taxpayers.  What has happened is that increasing numbers of people in Europe (and especially young people) are not working and being paid for by taxes on the employment of other people, which of course makes the problem worse. This is pushing the weaker parts of Europe into what I called in my April lecture last year ‘The Misery Cycle’ where an increasingly uncompetitive economy is leading to higher levels of unemployment which is paid for by increased taxation of employment which of course makes the problem worse.   The table in the slide shows annual working hours for a range of countries. It shows pretty clearly how much less we work in Europe. But it is interesting that the most successful countries in Europe are those that work fewest hours. I have always said that economics needs to be combined with common sense – that is why academic economists in the UK have contributed so little to our knowledge!   It would be easy to conclude from this that at least for Europe, the less you work the more successful you are. But this is a classic chicken and egg problem – if you are more economically successful you can afford to take more of the fruits of your success in shorter hours (particularly if there are high marginal rates of taxation which penalise those that work long hours). Common sense tells us that for people to assume that the fewer hours they work the more successful they will be is just plain daft. On the other hand, I think that we in Europe have in many ways a much better lifestyle and balance between work and leisure than our equivalents in the US for example (let alone Asia) who seem to me to take too few holidays, a problem compounded by the Americans’ reluctance to travel outside their own comfort zone or indeed country.    In Europe we do have also a problem, which is that there is an economic cost to our relatively short working hours and unless we adjust to the new economy that is emerging as a result of globalisation we will end up trapped in the misery cycle. Let me turn now to labour costs.   There is little good data on hourly labour costs that properly compares on a like for like basis the costs of people doing equivalent jobs in very different parts of the world.   But a firm called Werner International Management Consultants has made such a comparison for the primary textile industry. This is a relatively low paid part of the economy so I would not treat the data as truly representative of the whole economy. But the data, particularly for the emerging economies, is fascinating.   I am sorry that I have had to split the data table into two slides. And even then many of you will find the chart difficult to read so I will highlight the key points.   But it shows how much hourly labour in this industry costs in various parts of the world.   The most expensive (as those of you who go skiing will probably know) is Switzerland where the cost is nearly $50. Germany and France are around $30.   We in the UK are roughly $20.   In the US (and textile work is mainly in the South where traditionally the cotton was grown) the cost is $17.50.   In Korea and Taiwan, which are essentially developed economies, the cost is roughly $10 and not much more in Israel which is also a developed economy.   Much of the data on this page of the slide is well known and confirmed by international studies from the normal sources of this sort of data like the US Bureau of Labor Statistics and the OECD.   But if we turn to the second page of the slide we see the data that is hard to get.   China is up to $2.10 an hour and roughly as expensive as Thailand (and more so than Malaysia).   At the bottom are four countries with high birth rates and as a result cheap labour – Indonesia, Vietnam, India and Pakistan. Here hourly wages are $1 an hour or less.   In 2009 Nike shut down its factory in Suzhou China (formerly Soochow) and moved it to Vietnam. This table shows why… Last year Adidas also shut down its factory in China and moved it to Myanmar, where years of misgovernment have led to wages that are even lower than in Vietnam – the representative wages in December last year were 12 cents an hour, though the workers were on strike for a rise to 15 cents!   Although labour costs are rising in emerging markets and especially so in China where there is a demographic problem resulting from the one child policy, they are still massively below ours in the West and especially in Europe. One of the results of this is that Europe is becoming a much smaller part of the world economy. The Cebr’s world economic league table, which we released last December, showed how Western Europe was reducing as a share of the world economy. In 1998 Western Europe was 30.1% of the world economy. Our forecast for 2028 is that its share will have more than halved to 14.5%.   Obviously all advanced economies are losing shares of world GDP as a result of the rise of the emerging economies. But the loss of share is much greater for Europe. By comparison, the North American share is only falling back from 31.8% to 22.1% over the same period. To put this in perspective, in 1998 the North American economy was only 5.6% bigger than the Western European economy. By 2028 we forecast that it will be 52.4% bigger (sorry about the spurious precision!).   Growth   Europe’s lack of competitiveness has, especially in the present century, started to hinder growth. The IMF (International Monetary Fund) covers 188 countries in its World Economic Outlook, which most of us consultants use as an invaluable data source for the more obscure economies. Only three of these countries have had no growth in the present century. They are Italy, San Marino (which economically is a part of Italy) and Zimbabwe.   There are only 23 countries (including the three mentioned above) which have had less than 20% economic growth in the current century. Twelve of these 23 are in the Europe EU and all but one of these (Denmark) are in the Eurozone. The 11 who are not are Zimbabwe (as mentioned above), Micronesia, the Central African Republic, Jamaica, Barbados, the Bahamas, Japan, Haiti, Antigua, Libya, Tuvalu and Tonga.   There are four countries for whom data is not available for the whole period, Iraq, Afghanistan, Southern Sudan and Syria. Of these, the first two have definitely been growing for the past decade for which data is available, Southern Sudan only came into existence recently and Syria was growing until the civil war started, though I would guess that the civil war has probably made their growth performance over the whole of the 21st Century so far as bad as or even worse than Italy’s. I list the countries because it is important to see whose company we are keeping in the slow lane. With the greatest of respect to the government and peoples of these economies, they are not household names for economic success. It is true that other than in Italy, Europe’s lack of competitiveness has not yet caused growth to go negative in aggregate. But as I pointed out in my last lecture, living standards in the Western world are growing more slowly than GDP so that many of these twelve countries in Western Europe with slow growth will have living standards that have been declining or at best remaining static.   The flash estimate for the Eurozone GDP in Q4 of last year comes out on Friday. We are expecting growth for the quarter of 0.3%, led by Germany but with France pulling the total down. But even if Europe gets back to positive economic growth in the coming years, growth will still be slow so Cebr’s official recommendation is not to go out and buy the champagne yet, even if you are a European Bureaucrat or MEP and can get it on expenses.   Globalisation as an asymmetric shock to the Eurozone   Analysis of fixed exchange rate systems pay great attention to the impact of what are called asymmetric shocks. These are shocks that affect the different countries in the fixed exchange rate system differentially. The analysis here looks at the different trading patterns in the different parts of the EU and to simplify things I have focussed on trade with China.   The first thing to note (as we mentioned earlier) is that China is moving rapidly up the technology curve and is now competing against more than twice the share of EU exports that it did in 2000.  But what is an even more serious challenge is that by 2028, we estimate that the share of EU exports which will face direct competition from China will have risen to three quarters.   This looks at the EU in aggregate. But the asymmetry of the shock lies not in its absolute size but in the differential effects on the different parts of the EU.   Partly this reflects the different product sets. The World Bank lists 5,775 products that get traded. The larger European economies export about 4,000 of them. But the smaller economies can export no more than half that at about 2,000 different products. The World Bank has a measure of trade complementarity. This is a complex measure which looks at whether the exports from one country are more likely to compete with exports from another. This shows that 46% of German exports are complementary with Chinese goods whereas only 22% of Irish exports are such. The Germans make things like machine tools and high quality branded cars that the Chinese want to buy. At the other extreme, the textile industry, which not so long ago was a staple part of industry in Southern Europe, has all but been wiped out except at the high end in Europe by competition from low cost producers.   What this means is that globalisation has affected the different European economies differentially. This has greatly exacerbated the problems since the Euro started on 1 January 1999, just as globalisation was getting into full swing. Normally exchange rate flexibility is one of the cushions to the pain of asymmetric shocks. But in a fixed exchange rate system this is not there – instead the countries have to rely on internal devaluation which is a painful process since it damages domestic consumer spending at the same time as it boosts exports and curbs imports.   This is why (excluding San Marino which is effectively part of Italy), Southern Europe in the shape of Italy, Portugal and Greece have had the slowest growth in the world excluding Zimbabwe in the 21st century.   The slower than expected growth in Europe, combined with the lax fiscal discipline embedded in the Euro system meant that the weaker economies in Europe built up unsustainable deficits which cumulated into unsustainable debts.  Weaker than expected growth meant that governments implemented spending plans that could not be financed. Not only did government spending rise as a share of GDP – reaching 57% in France, which is now only slightly below the shares of public spending in Eastern Europe before the collapse of the Iron Curtain, but also tax receipts which are highly geared to growth have proved disappointing. And of course the lower than expected denominator meant that both deficits and debt as a share of GDP have been higher than expected. The combination of excess spending and revenue shortfalls led to deficits, which cumulated into debt which was the trigger for the Euro crisis.   My key point here is that the economic crisis in Europe is much more systemic than it appears.   The Euro itself has contributed to the crisis in three ways.    First, as mentioned before, the nature of competitive problems and asymmetric shocks is that they normally need exchange rate adjustments to cushion the blow. The fixed exchange rates intrinsic to the Euro meant that this did not happen. It could be argued that the international exchange rate for the Euro is about right for Germany. But it is clearly far too high for many of the other European economies. Because the exchange rate was not available to make this adjustment, the adjustment had to be made by an ‘internal devaluation’ through squeezed wages. This in turn hit living standards and hence consumption.   Second, the existence of the effective currency guarantee meant that many Eurozone economies which had got used to high interest rates because of their weak economies suddenly found themselves with German interest rates. In two countries in particular, Ireland and Spain, these low interest rates led to a wildly excessive building boom that when it bust left them with large amounts of empty property and a collapse in property values. Third, the weakness of the fiscal scrutiny mechanisms embodied within the Euro meant that the weaker economies were given plenty of rope to hang themselves. Had they had independent currencies, the markets would certainly have pulled the plug on their policies much earlier. And the problems would have been very much less intense. But I suspect that while this has added greatly to the volatility of these economies and made the boom and bust much more painful, I am not sure that it changed the outcome for GDP today all that much.   What all this means is that tinkering with the Euro will only do a certain amount to solve Europe’s economic problems. And even breaking the Euro up will solve some problems but at the expense of making things worse in the short term – countries leaving the Euro would have no currency at all for a short while and the markets would almost certainly overreact by excessively devaluing the weaker of the new currencies and revaluing the stronger ones. Although I am reasonably certain that Europe in ten years would be better off without the Euro, the path over that ten-year period would be a bumpy one.   How China saved the Euro   The Euro crisis really got going in late 2009 when concerns rose in the financial markets that Greece would default. They peaked in May 2012 when successive elections failed to produce a government in Greece that would take the decisions that would satisfy the lenders. But since the announcement of Outright Monetary Transactions by the incoming ECB (European Central Bank) chairman Mario Draghi on 2 August 2012, and with Greece eventually finding a government that at least pretended to be making the fiscal adjustments demanded by its creditors, the crisis has subsided. Ironically the Outright Monetary Transaction facilities have not actually had to be used. But the mere threat that the ECB might mount what market traders call a bear squeeze on speculators speculating against the government bonds of the weaker European economies has been enough to permit bond yields in the weaker economies to fall back. Today the yield on Greek government ten year bonds has fallen back to 7.53% and that on Italian government bonds of the same maturity to 3.68% - spreads of 5.85% and 2.00% against the benchmark equivalent German bond commonly known as the bund. At their peak in March 2012 Greek bonds yielded more than 12%, and at their peak in June 2012 Italian bonds yielded 4.85%.   What saved the Euro was that once the hedge funds had liquidated their positions in the face of the bear squeeze, the recovery was enough to persuade the Chinese to invest their foreign exchange reserves in Euro denominated assets as well as making transactions in the weaker bonds. It is well known that China has accumulated huge foreign exchange reserves as part of its policy of keeping the RMB (the Renminbi, the official Chinese currency) on a stable path. In January 2014 Chinese forex reserves were $3.8 trillion. The composition of Chinese forex reserves is a state secret. But it is possible to do some detective work on this and work out rough percentages.   This slide shows China’s forex holdings by currency estimated  by Wang YongZhong and Duncan Freeman to 2011.   What has happened since then?   The Chinese leadership have given us some clues.   In contrast to widespread scepticism vis-à-vis the Euro (mainly stemming from Anglo-American banks and hedge funds), Chinese leaders have consistently been more optimistic, intervening on a number of occasions since the beginning of the Euro-crisis to reassure financial markets and European leaders that they would continue to buy Eurozone bonds and bolster the common currency. Political considerations have also played a role: Chinese leaders have traditionally supported a stronger and more united Europe that could work alongside Beijing to counterbalance American primacy. In March 2009, Zhou Xiaochuan, the then People’s Bank of China (PBOC) governor, explicitly called for the creation of a new international reserve currency while reiterating China’s support for the Euro. The Chinese government explicitly backed the European Financial Stability Facility (EFSF) – replaced in October 2012 by the European Stability Mechanism (ESM) – fund of €440 billion rescue fund for Portuguese, Greek and Irish government bonds. Nicola Casarini, Senior Analyst at the Paris-based European Union Institute for Security Studies (EUISS), estimated that by March 2013, the proportion of Chinese reserves invested in the Eurozone had risen to a third from its traditional 25-30% (note this definition is slightly different from that used by the authors of the previous slide). In October 2013 the PBOC and the ECB announced their first currency swap deal. It is no coincidence that this has followed the opening of the Shanghai Free Trade Zone in the same month. Meanwhile an analysis by Dow Jones Newswires has also confirmed the likely trend of the Chinese government shifting reserves to Euros .   Our own work has tried to put the pieces of the jigsaw together, balancing movements in China’s reserves with market movements in the currencies and bond yields.    Our tentative conclusion is that the proportion of China’s forex reserves in Euros is now close to 40% compared with its historic 25-30%. And most of this rise has happened since mid-2012.   If this is correct, it is clear that China has saved the Euro, at least temporarily.   There is no shortage of conspiracy theories for why the Chinese might like Europeans to be in their debt. But China’s support for the Euro is actually in China’s interest anyway. The Chinese have never liked the Dollar’s status as the main reserve currency and have therefore a strong interest in strengthening rivals to the Dollar. But this policy is given added momentum by the gradual emergence of the Renminbi (RMB) as a major currency in its own right. The RMB will eventually be the world’s first or second currency but is currently held back by its limited acceptability. It makes sense for the Chinese to support the Euro as an alternative to the Dollar until the RMB becomes more internationally tradable.   So globalisation was probably the single most important explanatory factor behind the Euro crisis. But it was one of the consequences of globalisation – the Chinese accumulated reserves - that saved the Euro from being wrecked as the markets took against it two years ago.   This is all not entirely good news for the Eurozone.    Even if there is no conspiratorial explanation for the Chinese holdings, it still places Europe in Chinese debt and subject to Chinese pressure.   And although the intensity of the Euro problem has gone away, growth is anaemic and a longer-term solution will be required. Can the Euro survive?   What I have pointed out so far is that Europe’s economic problem transcends the Euro. Getting rid of the Euro would change its dimensions, but many of the problems would not go away. And getting rid of the Euro would create its own problems in the short term though our calculations show that European GDP would be higher if the Euro was scrapped within ten years and probably within five years.   But a longer-term solution for the Euro will probably involve transfers within Europe. As I have mentioned before, I was effectively apprenticed as a young economist to Sir Donald MacDougall, who was my predecessor as the Chief Economic Adviser to the CBI. Sir Donald wrote the MacDougall Report which was published in April 1977 . The MacDougall report pointed out that the role of fiscal transfers between different countries in Europe was tiny compared with the transfers that take place within Member States. This is even more so today – London pays out a fifth of its income in transfers to the rest of the UK. Donald’s report concluded that to integrate Europe public spending of about 20-25% of GDP would be necessary at an EU level. Despite being a Blairite (Donald told me over lunch during his last week before he died at the age of 91, a week when besides lunches he went out in the evening four times, that he thought Tony Blair had been Britain’s best ever Prime Minister), he was vehemently opposed to the Single Currency arguing that it would reinforce the economic gap between rich and poor countries within the Eurozone.   There is an obvious trade that would sustain the Euro in the longer term, even though the pressures from globalisation are set to increase. Long-term transfers from the richer economies to the poorer economies combined with much more intensive economic control by the creditor countries of the budgetary positions of the debtor countries. But whether the Euro will survive is likely ultimately to be in the hands of the voters. Will German and other Northern European voters vote for continued subsidies? And will the weaker economies accept foreign economic control? The answers to these questions will determine whether the Euro survives. And finally…   What about the UK?   With a possible referendum in the offing allegedly in 2017, is it in our interest to remain in?   The Swiss have already voted in a referendum this week to break their Single Market Treaty with the EU on immigration, though by a very tight majority. The response of the EU is yet to be seen, but they will respond to the Swiss with one eye on the Brits. Cebr is carrying out some work on the subject and we will know more when the work is complete. We have, in fact, been commissioned by both the pro-EU forces and the anti-EU forces to study different aspects of the issue. Which fits well with our current view that the impact of leaving the EU is quite finely balanced. What is clear is that the negative impacts are likely to be short term while the positive effects are likely to be longer term. I certainly do not know at this stage how I will vote if there is a referendum. But I suspect it will depend on two things; first – how much the EU itself will have to adjust to keep the Eurozone together if it succeeds in doing this; and secondly how far they are prepared to go in adjusting the UK’s terms of membership, which increasingly do not suit the UK and have not done so since Gordon Brown’s government allowed M. Barnier to become the single market commissioner with his avowed aim of attacking the City of London. While there are plenty of things in the City that need reform, M. Barnier is not the solution. I hope this sets aside Will Hutton’s description of me a few weeks ago in the Observer as ‘An affable Eurosceptic’. I am not sure that I am affable, and my positions on both the EU and the Euro are much too nuanced to be covered by the blanket category of ‘Eurosceptic’.     © Professor Douglas McWilliams, 2014