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Economic Premise OCTOBER JUN 2012 010 •• Number Numbe 92 18

The Euro Experience and Lessons for Latin America Carlos Hurtado

It is natural to think, and economic theory predicts, that integration in an economic zone like Europe fosters growth and development, particularly when integration refers to trade opening among countries. It is expected that openness (to trade) promotes growth and being closed (to trade) deters it. Trade theory also concludes that (trade) integration is beneficial to all countries, large and small, and that small economies are likely to benefit relatively more from integration. This note reviews the development of the European Union’s euro zone and its impacts on growth and finds lessons that can be useful for Latin America.

Growth and Convergence in the Euro Zone Introducing a common currency as a stronger form of integration would promote growth beyond trade integration alone, because of at least one reason: improved access to financial markets. Sovereign debt denominated in euros has lower interest rates and better conditions than individual currency debt of countries’ from those referred to as “peripheral” in Europe. After joining the euro zone, Greece, Portugal, Spain, and Ireland could suddenly, and nearly unlimitedly, access credit markets at lower costs. Capital inflows to those countries were huge between 1999 and 2007 and boosted expenditure in various forms. Figure 1 shows how sovereign risk relative to Germany virtually vanished for all countries. Governments of today’s troubled countries could sell debt and banks could buy it very much in the same way they bought German bonds. Significant capital flows poured into Greece, Portugal, Ireland and Spain, which we call “emerging” economies after the establishment of the euro zone. Naturally those flows facilitated major increases in domestic absorption. Table 1 shows the evolution of per capita growth in the euro zone countries in different time periods. Growth does

not accelerate after the adoption of the euro for the group as a whole, but it does for the “emerging” economies, especially for Greece, Ireland,1 and Spain between 1999 and 2007. In contrast, Portugal’s gross domestic product (GDP) per capita growth decelerated strongly after the adoption of the euro. The solid growth of 1999–2007 cannot be clearly attributed to the common currency. Non–euro zone members of the European Union also did better after the euro was adopted. The performance of Denmark, Sweden, the United Kingdom, the Czech Republic, Hungary, and Poland2 in terms of per capita real income was slightly below the euro zone group in the years before the adoption of the euro, 1990–99, but it was significantly higher in the euro years of 1999–2007.3 In that same period, there was a tendency toward convergence in the European Union (again, not exclusive to the euro zone countries). Figure 2 shows the evolution of per capita income in U.S. dollars based on purchasing power parity of the emerging countries, including some outside the euro zone— Slovenia and the Slovak Republic were outside the euro zone from 1999 to 2007—relative to that of Germany, which is arbitrarily chosen as a reference for convergence. There was a tendency toward convergence, as the GDP per capita of the

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Figure 1. Ten-Year Bond Yields before and after the Adoption of the Euro 16

14

10-year bond yields, percent per annum

Germany Austria Netherlands France Belgium Ireland

euro is launched, January 1999

Spain Finland Italy Portugal Greece

12

10 Greece joins the euro, January 2001

8

Stability and Growth Pact watered down, March 2005

6

4

2

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

January, May, September Source: Bergsten and Funk Ki rkegaard 2012.

Table 1. Real per Capita GDP in Domestic Currency at Constant Prices, Euro Zone Group (cumulative rates of growth, %)

l

Country l i

Austria

e

1990–99 t fG

l f ll

1999–2007 (

2007–11

1999–2011

16.1 this

2.2 ft

18.6 the

tain 13.8 eb 28.7

cing -0.5 pr -2.5

risk 13.2 or 25.5

cause Belgium

i t Finland

9 d18th olos 19.2 a 12.5

France

12.8

11.6

-1.9

9.4

12.4 s we

13 9 fina

2.7 ve

17 ally0

fica 12.4

fi Germany pri a low Greece irre Ireland

iv 37.1 un 32.8

est -11.0r

gy 22.0

heir 64.6

-14.6

13.4

Italy

12.4

8.0

-7.0

0.4

Netherlands

24.2

15.2

-0.5

14.6

7.6

-3.9 e

Average

28.0f ay i o 23.1 o

ce o 29.3 eres

con -5.8 y

3.4 ng ith 12.4 ar a

U d Portugal nab it Spains

21.9

19.5

d

”

3.9

Sources: Outlook pri IMF, l g World ” L Economic ge li andDatabase p i te e r g Note: Slovenia adopted the euro in 2007 and the Slovak Republic in 2009.

emerging economies approached that of Germany and the trend was reinforced after the adoption of the euro in 1999. However, this phenomenon is not limited to the euro zone countries. In fact, Poland, the Czech Republic, and Hungary

13.6

show the same behavior toward convergence as the rest, as do Slovenia and the rope p licymak rs’ Slovak itial Republic. enial and oupled wi h fi i l ma e s lur prop rly assess Experience of the Euro Zone Emerging i e s o diffe e t ur rea o n rie n tend Economies in the First Nine Years As relatively join tha the eur small area economies when it was fi the all common struck bycurits rency zone andcrisis enjoyineasier accesswas to financial ious financial 2008–0 hit by amarkets double aty of lower and strong inflows, their current hugecosts pre-cris s publ capital c and private debt overhangs account deficits enlarge their surpluses decline). ulty institutiona design (or ha prevented an expeditious spontaneously nAggregate that wou expenditure d be credibl should to tho increase e same markets in the form of consumption or investment, and the higher absorption would appreciate the real exchange L IfI Cthe A appreciation IG B is not E E accompanied E E B by A inD rate. ST S V E economy EUR creasedE productivity, the would suffer a loss of competitiveness in the tradable sector.4 In i fi i i goods ti k general, t “ that i is the h rpath,r described ” Th below from 1999 to2007, i followed f ll by the group n u of i emerging i d s European economies—Greece, Ireland, Portugal, fl i EC and Spain—and t also of Italy and France, with some fi fi l iy i ll plnotable exceptions: i l l i • First, resources from l all fi of them i l absorbed Th significant u abroad, account i i iran increasing hi p current i l deficits, i i t and experienced major GDP growth and gains in terms of employment, with the exception of Portugal, whose rate of unemployment nearly doubled in that period.


Figure 2. Gross Domestic Product Per-Capita Based on Purchasing Power Parity

The Euro Zone After 2007

1.3 1.2 1.1 1.0 0.9 0.8 0.7 0.6 0.5 0.4 0.3

ratio over Germany

During the first nine years of the euro, the emerging countries developed different kinds of bubGermany Greece bles, which eventually burst. Credit then came to Ireland a sudden stop, and the economies stalled and Portugal Spain found themselves with extremely high levels of Czech Republic deficits and debt and lost competitiveness. Figures Hungary Poland 4–7 describe in general terms developments from Slovak Republic 2007 until 2011. Slovenia After 2007, growth turned to stagnation and 1995 1999 2007 2011 recession and the trend toward convergence was Source: IMF and World Economic Outlook Database. interrupted and the unemployment decline reversed. The substantial current account deficits • Second, aggregate expenditure generally increased in the of 2007 have been reduced, but remain too high in the trouemerging economies, but in different fashions. Spain and bled economies. Fiscal deficits have decreased, but are still Ireland saw their investment expenditure increase and well above the desired targets. Public debt—from persistently generally kept their fiscal accounts under control. Conhigh levels of public expenditure and/or from assumptions versely, Greece and Portugal experienced a period of high of debt from the financial sector—remains above desirable expenditure not reflected in investment—their ratio of levels. And, drawing from figure 3, productivity gains and/ investment to GDP declined in 2007 with respect to or cost reductions to date have proven insufficient to return 1999, especially in Portugal, and they expanded public to 2000 levels of competitiveness, relative to more advanced expenditure significantly. economies, particularly Germany. • Third, in both Spain and Ireland there was a major reduction of public debt, and in both countries public indebtThe Policy Issues in the Euro Zone edness appeared manageable by 2007. Contrastingly, in Greece and Portugal, public debt as a proportion of GDP While things went well, several drawbacks or risks of the multiplied by about three times between 1999 and monetary union were not apparent in the early years, but are 2007, rising to over 100 and 60 percent, respectively. evident today. This section discusses some of the most impor• Fourth, from 1999 to 2007, Italy and France experitant issues. enced growth, a decline in unemployment, absorption of Adjustment in the euro zone has been difficult and eluresources from abroad, increased investment, and mainsive, partially due to the rigidity of the fixed exchange rate. tained control over their fiscal accounts. By 2007, the The economies, whose aggregate expenditures grew signifistructural fiscal deficits of Italy and France were around cantly for years and faced a sudden stop in terms of capital 2.5 and 2.9 percent, respectively, and their public debt– availability, are suddenly forced to reduce the real values of to-GDP ratios were comparable to those of 1999. several variables. That is, a real depreciation. But they have to • Fifth, and most importantly, unit labor costs increased in do it without a nominal devaluation, which would facilitate it. all the “emerging” economies under consideration by They are forced to reduce nominal values of public and private more than 20 percentage points over German unit labor expenditure, social security benefits, debts, assets, and wages. costs between 1999 and 2007, reflecting a sharp loss of This has been called a fiscal devaluation, and has proven to be competitiveness. extremely difficult to carry out.

10

09

20

08

20

07

20

06

20

05

20

04

20

03

20

02

20

01

Source: OECD statistics.

20

20

20

19

00

Greece Ireland Portugal Spain Germany

150 140 130 120 110 100 90

99

index

Figure 3. Unit Labor Costs in Selected Euro Zone Countries, 1999–2010

In contrast to the case of a state within a federation, in the European Union, labor and capital do not migrate to other member states fast enough, so that the shock is not mitigated and is reflected domestically in price reduction and unemployment. Factor mobility is not as high in the European Union. Notably, the lack of expeditious migration has resulted in a coexistence of historically high levels of unemployment in the emerging economies, with historically low levels in Germany. Additionally, capital flows were substantial, but were mainly cross-border transactions of claims and liabilities, while equity has not been as mobile, so that a good part of the capital losses have been realized domestically.


6

1999–2007

5

2008–11

4 3 2

Sweden

Poland

Denmark

Hungary

Czech Rep.

Euro area

France

Germany

Italy

Finland

Netherlands

Austria

United Kingdom

4

Greece

3

Belgium

2

Slovenia

Portugal

1

Spain

0

Slovak Rep.

1

Ireland

average real GDP growth (%)

Figure 4. Average Real GDP Growth, Euro Zone and Non–Euro Zone Countries

Source: IMF and World Economic Outlook Database.

France 2000 2007 2008 2009 2010 2011

Figure 7. Net Public Debt to GDP

11

10

20

20

09

20

20

08

Greece Ireland Portugal Spain Italy France

07

20

20

05

04

20

06

150 130 110 90 70 50 30 10

20

The absence of stronger integration, like a fiscal union, has proven to be problematic. Euro zone countries do not have a mechanism to distribute losses and wins among states, as is the case in most federations. Further, there is no solidarity among constituencies, which complicates political commitments. Therefore, the political leadership of the stronger countries finds it difficult to come up with support for the troubled countries. The absence of common budget authority and treasury impedes fiscal coordination. National public expenditure and/or debt in the troubled countries rose to unsustainable levels, and there is no overall European authority to oversee sustainability of the aggregate. And the Maastricht agreements were loosely defined and in the end not respected. There is no lender of the last resort. Much related to the last point, it appears that before 1997 there was an implicit belief that somehow the European Union would act as a lender of last resort. But since the sovereign risk became (suddenly) evident, and the cases of insolvency and illiquidity started

Italy


03


02

-13

2007 2011

20

-11

01

-9

20

-7

20

-5

00

-3

2 Greece Ireland Portugal Spain 0 -2 -4 -6 -8 -10 -12 -14 -16 -18

20

-1

Figure 6. Structural Fiscal Balance

99

France

net public debt/GDP (%)

Italy

19

current account/GDP (%)

Greece Ireland Portugal Spain

structural balance/GDP (%)

Figure 5. Euro Zone Countries Current Account Balance


to appear, there has been much uncertainty and argument around the idea of aid or rescue for the troubled countries, which has made it difficult to gain credibility from markets. The point is, different from the United States, institutionally the European Union was not and still is not prepared to deal with massive financial failures.


Failures of financial supervision, both in internal and cross-border operations, also exacerbated the problems. This is evident when considering the real estate bubbles and the growth of banks’ balance sheets that took place before 2008. Moreover, banks in Europe had several incentives to buy the sovereign debt of any euro zone country, because the market and the European Central Bank in its repurchase operations treated all of them equally. The Way Ahead Much of the recent literature on the European crisis includes reasonable recommendations for solutions; but it has just not been possible to come up with a credible plan to implement them. Even after the financial arrangements were made to rescue Ireland, Portugal and Greece, the situation has remained rather unstable over the past year. On more than one occasion, the yields of Italian and especially Spanish bonds have gone up to alarming levels. After a difficult election and the formation of a new government in Greece, doubts continue to arise, not only regarding its capacity to carry out the required adjustments, but also on the likelihood of remaining in the monetary union. Spain has reluctantly accepted rescue funds from the European Union, but the markets remain doubtful. It has not been possible to design an effective strategy to move past the crisis, maybe because it is extremely difficult to get agreements and solid commitments about difficult topics, including but not limited to: • ways to isolate (firewalls) cases of insolvency and excessive indebtedness; • definitions of financial arrangements and backstop mechanisms to deal with them; • financial arrangements with sufficient resources to provide a backstop signal for countries with liquidity problems (these imply clearly defined and predictable support from the European Central Bank and the European Stability Facility); • mechanisms to assure long-term fiscal sustainability; • a commitment toward a “minimal” fiscal Europe, enforcing the disciplines of the agreements of the “fiscal compact” and strengthening both internal and cross-border financial supervision (referred to as banking union); and • a carefully calibrated macroeconomic strategy to exit from the crisis, given the trade-offs between the awakening of demand and the eventually needed monetary tightening to control inflation, as well as between the conditions to restart growth and the fiscal adjustment. Even if all these and other necessary actions are successfully taken, it is expected that policy decision making will be slow, troublesome and “bumpy,” and that the European Union will experience several years of slow growth with repeated episodes of uncertainty and instability in financial markets.

Meanwhile, the individual, most troubled emerging countries—Greece, Ireland, Portugal, and Spain—are being forced, by institutions or simply by the circumstances, to undertake extremely difficult domestic reforms and measures to retake control of public finances and, most importantly, increase competitiveness, as well as other plans including: aggressive and credible plans to reduce public expenditure and increase taxes; reduction of public debt; reductions of wages, pensions, and other social welfare benefits; and reform several pieces of legislation, notably labor laws. The euro experience provides lessons for other countries, especially for Latin America. Obviously these measures and reforms can be difficult to implement, but it is much better to carry them out in times of growth and stability—that is an important lesson of economic policy. Policy Implications for Latin America Latin America has appropriately dealt with the economic downturn and instability and its economic growth has been historically strong. However, when compared with other successful experiences, it is not as strong and does not seem to be based on solid foundations. Some of the shortcomings are detailed below:5 • Growth during the last nine years (2003–11) is higher than that of Europe in both cycles, 1994–2000 and 2003–11, but it is lower than growth experienced by East Asian countries in both 1981–95 and 2003–11, and by South Asian countries (plus Israel) in 2003–11. • By any standard, Latin America’s productivity has been lagging behind other regions. This is also suggested by the increase of GDP per person employed in Latin America in 2003–8, which is lower than in East Asian countries during 1981–95 and 2003–8, and South Asian countries in 2003–8, and Europe in 1994–2000. • Trade measured by exports as a percentage of GDP (2002–10) is well below the world average and the East Asian economies, even though Chile and Mexico are quite high. The region’s trade as a percentage of GDP is only marginally above that of South Asian economies. • The World Bank’s Ease of Doing Business index rankings vary in the region: rankings are generally well below East Asian economies, while some countries’ rankings are comparable to “medium table” European economies, and other countries’ rankings are similar to those of South Asian countries. • The World Economic Forum’s competitiveness index 2011–12 is lower than those of European and East Asian countries, and, on average, it is similar to those of South Asian countries. • The quality of education as measured by the Programme for International Student Assessment (PISA) 2009 test results is clearly lower than in Europe and Southeast Asia.


Important structural problems remain and need reform. The main lesson that can be drawn from the European experience for Latin America is that it is advisable to take advantage of the current context of growth, stability, and optimism to carry out much-needed reforms that will leave the countries adequately prepared to face a downturn in the world economy. Particularly important are reforms to increase productivity along with appreciation of the real exchange rate to avoid losing competitiveness. Specific areas for reform include social security and labor laws, competition and bankruptcy laws, property rights, and education and judicial systems, among others. Similarly, fiscal policies and institutions could be reformed to tackle major deficiencies. Tax regimes and administration—including customs— face significant challenges, and expenditures need to be controlled. Moreover, some countries would benefit greatly from structural deficit rules, and there are also instances where pension reform is urgently needed. In the financial sector, it would be worthwhile to review macroprudential regulation and supervision mechanisms as well as the role, size, and contingencies of the development banks. About the Author Carlos Hurtado is a World Bank consultant for Poverty Reduction and Economic Management (PREM) in the Latin America and Caribbean Region. Notes 1. Because of the condition of Ireland as a tax haven, it would be better to consider gross national product (GDP) as an indi-

cator for several purposes. Ireland’s income is somewhat overestimated by GDP in the 1990s, when many enterprises located their headquarters there. 2. Non–euro zone countries not considered here include Bulgaria, Latvia, and Lithuania. 3. Real per capita GDP grew by 28.8 percent on average for these non–euro zone countries, compared to 19.5 percent in the euro zone. The former is strongly influenced by Poland’s growth, which has been especially high over the last two decades. But even without considering Poland, the non–euro zone countries real per capita GDP did better in the first nine years of the euro. 4. The effect of loss of competitiveness due to capital inflows and real exchange rate appreciation is similar to what is commonly referred to as “Dutch disease,” where the absorption of resources comes from high prices of a certain exportable commodity and the rest of the tradables sector is “squeezed.” 5. Hurtado (2012a) presents data supporting these assertions. References Bergsten, F., and J. Funk Kirkergaard. 2012. “The Coming Resolution of the European Crisis.” Peterson Institute for International Economics Policy Brief PB 12-1, Washington, DC. Hurtado, Carlos. 2012a. “The Euro Experience: A Review of the Euro Crisis, Policy Issues, Issues Going Forward and Policy Implications for Latin America.” Inter-American Development Bank Department of Research and Chief Economist, Policy Brief, No. IDB-PB-167. This brief also contains a comprehensive list of references for further reading. Hurtado Carlos. 2012b. “La experiencia del euro Implicaciones de política económica para Latinoamérica.” Foreign Affairs Latinoamérica 12 (3).

The Economic Premise note series is intended to summarize good practices and key policy findings on topics related to economic policy. They are produced by the Poverty Reduction and Economic Management (PREM) Network Vice-Presidency of the World Bank. The views expressed here are those of the authors and do not necessarily reflect those of the World Bank. The notes are available at: www.worldbank.org/economicpremise.
