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Michael Pettis on Misguided European Optimism
Via Email, Michael Pettis author of "The Great Rebalancing" (see "Great Rebalancing" Book Review: Two Thumbs Up) dispels the myth that Spain and peripheral Europe are on a sustainable rebalancing path relative to Germany.
Pettis writes ...
Several euro-optimists have pointed out that unit labor costs in Spain have dropped substantially relative to Germany, by as much as 6 or 7 percentage points. This whole reform process is working, they claim, and if we can just wait it out another year or two Spain will be fully competitive again.
I am not so sure. Although I agree that there have been real economic reforms, I am a lot less sanguine about the ability of these reforms to stave off the crisis. First, the reforms have come at a huge social cost, and it isn't obvious that people can suffer much longer as they already have. After all we know how to force down unit labor costs. It is really quite easy. High unemployment usually does the trick.
The problem is that Spain, after four years of punishingly high unemployment, has only clawed back in labor competitiveness about one-third of what it needs to claw back in total, and Madrid has already picked most of the low hanging fruit. As brutally difficult as this has been, this was the easy part. For Spain to claw back other 10-15 percentage points in unit labor costs, and it may need more, may well be beyond the capacity of the population to endure.
Second, labor is only one factor in international competitiveness. Capital is the other, and everyone is in a hurry to forget this. It is hard to calculate the appropriate trade-off, but while relative labor costs in Spain have certainly declined, the relative cost of capital has just as certainly risen, and probably by a lot more (to the extent that businesses can even get capital).
Some people might argue - and do - that the sharp contraction in Spain's current account deficit, from 5% of GDP in 2008 to around 1% today, shows that Spain has indeed become more competitive, but this of course isn't at all obvious. Much of the "improvement" seems to have occurred because of a drop in imports, which suggests greater export competitiveness hasn't played much of a role.
Unemployment levels well above 15-20% (and I assume official unemployment of 26% is probably overstated by the failure to account for the "black" economy) are an incredibly effective way of forcing a trade deficit to contract, because when people can't buy anything, they also can't buy tradable goods. As they stop purchasing those tradable goods however these goods would necessarily have been diverted to exports, even without any improvement in the country's overall competitiveness. This might imply that whatever increase in exports we have seen may be no more than the export of goods that Spaniards used to buy but no longer can. This kind of export performance is not a consequence of improved competitiveness. It is simply a consequence of rising unemployment.
What's more, if Spain is ever going to repay its very rapidly rising debt, it needs a lot more than a lower trade deficit. In order to repay its debt, Spain needs a very high current account surplus, and given Spain's huge interest burden, this actually means it needs a whopping trade surplus since the trade surplus has to exceed the interest outflows before it can be used to pay down debt. If unemployment is the best tool to get us there, I am not sure the Spanish population can bear the burden needed to get us the necessary high trade surplus.
So in spite of the good news in the Spanish bond markets, I still don't think we can pop the champagne corks. Except for the debt refinancing costs, the underlying fundamentals have not gotten better in the last six months. At best they are unchanged, and probably they are worse.
How long must Spain hold on to prove how serious it is about staying the course? A lot longer, I think. After all it wasn't until around 1931-32 that France began suffering from its membership in the gold bloc, but they doggedly held on until 1936 when they finally threw in the towel and devalued. The Spaniards are proving tougher than the French were, possibly because among the older generation (although not so much the younger) there is a tremendous residual worry (and shame) that Spain might not truly be European, and this is creating much of the loyalty to Europe, of which the euro is the great symbol.
But the Spanish still have a lot of pain to absorb. By the way if we were to see an intensification of the debate in France about the euro, I suspect that this will give a green light to Spanish public intellectuals, for whom France is the North Star, to discuss the prospect themselves. Until then, in Spain you are not really supposed to talk about abandoning the euro if you want to be taken seriously. It is a little like England in the 1920s, when for much of the policymaking elite abandoning the country's free trade principles and leaving gold were unmentionable - until many years of unemployment suddenly made both policies very "mentionable" in the first years of the 1930s.
In my opinion the happy bond markets are, as they have so often been under similar circumstances in history, a little premature. I think the phrase "there is light at the end of the tunnel" was popularized by Herbert Hoover around 1931, when the US stock markets staged a strong rally, convincing him and others that the crisis was over. Of course it wasn't, and the buoyant markets gave back everything and more over the next three years.
Investment Ideas for Unconventional Times
Michael Pettis will be a speaker at an economic conference I am hosting on April 5th in Sonoma, California.
For conference details, please see Wine Country Conference.
World-class speakers at the conference include John Hussman, Michael Pettis, Jim Chanos, John Mauldin, Mike "Mish" Shedlock, and Chris Martenson.
Yahoo! Finance Joins the Conference
I'm pleased to announce that Yahoo! Finance is joining the conference as our media partner. The wonderful Lauren Lyster, of Yahoo! Finance's Daily Ticker, will be moderating several of the panels for the day.
This is an experience not to be missed. The access you will have to these speakers and their insights doesn't happen easily. This is the first time many of these speakers have ever appeared together.
The event is made possible in part by a generous $100,000 matching grant by the John P. Hussman Foundation for the benefit of ALS Research.
For my personal experiences with ALS, please see My Wife Joanne Has Passed Away; Stop and Smell the Lilacs.
Hope to see you at the conference.