The wages of recovery
Everywhere in Europe the talk is of the need to cut costs. Companies have no choice but to respond to declining profits by reducing expenses. But too many European governments seem to believe that their economies will be able to overcome the downturn by increasing their price competitiveness and hence their exports. The unprecedented wage freezes and even wage cuts now taking place across European industry are not laying the groundwork for recovery but for slump and deflation.
We know where this leads. Germany has spent years holding down real wage growth. The result has been stagnant domestic demand. This worked for Germany because it could rely on buoyant external demand. But with everybody following the same strategy, the outcome will be much more damaging. What might appear to make sense in individual cases will be very damaging when pursued by all.
Some economies have no choice but to cut wages if they want to stay in the euro zone. Spain, Ireland, Greece and Italy have to do so if they are to regain competitiveness. If they don't, investors may fear that their growth prospects will be permanently handicapped, raising questions about their fiscal solvency.
But the problem for Europe is that the countries running large external surpluses will respond in the same way. The Netherlands has a current-account surplus equivalent to 7% of GDP, but there is little disagreement in the country that the way out out of the downturn is more of the same: Boost external competitiveness through wage and other cost cuts, and raise exports. Finance Minister Wouter Bos has ruled out any significant stimulus on the grounds that it would simply leak out of the country, and instead called for renewed fiscal discipline across Europe.
Then there is Germany. Despite the huge contraction now under way in Europe's biggest economy due to collapsing exports, the government continues to see external price competitiveness as the key to future prosperity.
As Chancellor Angela Merkel recently put it: "The German economy is very reliant on exports, and this is not something that you can change in two years. It is not something we even want to change." Savage cost-cutting in Germany is now all but inevitable; little importance is attached to ensuring growth in domestic demand.
But European countries will be taking a huge risk if they think they can simply wait for external demand to recover and resume export-led growth. They cannot hope to escape the recession by becoming more competitive relative to one another - unless, that is, they count on global demand to drive economic growth and on Europe to run an ever larger trade surplus with the rest of the world.
But this is not going to happen. The imbalances that powered growth in world trade in recent years are unwinding, and the global economy is set to remain weak for years. Import demand is contracting in the U.S., so there is no way Europe could run a bigger surplus across the Atlantic. With demand also collapsing in Asia, Europe's deficit with that part of the world is set to rise, not fall.
Some European countries will be better at cutting wages than others, but even those that are good at it will struggle with a chronically weak external environment. With everyone trying to restore growth through wage deflation, export-led growth will prove elusive, even for the most ruthless cost-cutters. The impact on Europe as a whole will be dire. Economic growth will stagnate, living standards will fall, and deflation will become entrenched.
Europe must concentrate on boosting domestic demand, and this needs to be coordinated at the EU level to prevent free-riding. In the short term, this means more macroeconomic stimulus. According to the International Monetary Fund, Europe's combined stimulus, including automatic stabilizers such as generous unemployment benefits, has been around half the US one. Making matters worse, the European economy is contracting more rapidly than the US one is.
Chancellor Merkel and French President Nicolas Sarkozy claim that we must wait until the end of 2010 to see if the existing fiscal measures have been successful. Europe cannot afford to be so cautious. By the end of 2010, the Continent could be in a slump, and deflation entrenched. Fiscal positions will then be too weak to mount further stimulus packages. The European Central Bank also has scope to cut interest rates further and commence quantitative easing. If not now, when?
In the longer term, if domestic demand is to expand more rapidly in EU countries such as Germany, greater productivity growth is needed in the service sector. Services account for around 70% of GDP in the EU - around five times more than manufacturing does. Yet service-sector productivity - unlike manufacturing productivity - has been anemic for many years, to a large extent because of high levels of national regulation and a low level of integration of service sectors across Europe. The EU needs to redouble efforts to break down barriers to the trade in services.
Long-term growth prospects in Europe depend on preventing a self-defeating competition of beggar-thy-neighbor wage cuts, as well as making service industries more productive. Avoiding wage cuts means doing everything possible to stimulate domestic demand. Boosting service-sector productivity means overcoming resistance to more competition at both the national and EU levels. Far from protecting living standards, opposition to reforms aimed at opening up service industries is a major obstacle to improving Europe's economic prospects.