Strange Bedfellows

From boon to albatross: there ain't no such thing as a free lunch

Strange bedfellows, Ireland and Italy. To be thrown by the latest EEAG Report on the European Economy into the same sack together, the one being a successful economy and the other struggling to avoid economic decline, must surely be an error?

Not really. Both came under the EEAG’s magnifying glass for the same reason: both economies could well be about to face a turn for the worse. The underlying factor is the monetary union they are a part of and the way individual economies adjust to country-specific shocks.

In the case of Ireland, its problem is excessive monetary stimulus from the ECB, which cut nominal interest rates in response to high unemployment in the euro area. In the case of Italy, it is the recessionary shocks it has experienced in the form of a fall in external demand and adverse —read downright calamitous— productivity developments. In the absence of a monetary union, each of these countries could have adjusted their respective exchange rate in order to relieve the macroeconomic stresses caused by the shocks, albeit in opposite directions. But the EMU straitjacket does not permit that.

This means that prices and wages —key elements of a “real” exchange rate— would have to move instead. And those two are famously sticky, in particular wages. Too sticky, and the result is inefficient levels of output and employment and a misalignment of relative prices. To compound the problem, when they do move, these adjustments do not work symmetrically: Real depreciation in response to negative shocks is typically much slower than real appreciation resulting from a positive shock.

This, in turn, gives rise to persistent “competitiveness problems” in countries hit by negative shocks, while in economies exposed to expansionary shocks the problems are excessively low perceived real interest rates, which overheat the property sector and cause a hard landing when they unwind. That should ring a bell in Ireland.

The Irish Case

...And nowhere to run

Irish labour costs have risen rapidly (albeit not as fast as they would have risen under full flexibility), but Ireland’s export performance has not been affected negatively because it has specialised in areas where the dynamics of world GDP have carried it along—and world GDP has been quite sprightly these past few years. Conversely, this also means that the country is vulnerable to changes in the global outlook: a downturn in world demand in the areas where Ireland has specialised could pose a macroeconomic risk. The strongest risk, however, comes from a possible misperception that Ireland’s highly successful convergence drive can be made to go on for a fairly long period of time, a perception that can lead to unsustainable consumption and investment plans.

One way this would affect Ireland is through a slump in the housing market. While the growth in its housing stock has been to some extent a by-product of the convergence process, as the capital–labour ratio approaches the long-run equilibrium level, the pace and intensity of housing investment have arguably been amplified by monetary stimulus at the euro level. Saving has not increased by as much as it should to take advantage of the recent income gains, and currently low real interest rates are wrongly perceived to be permanent. This strong expansion in the construction sector, coupled with the high market valuation of real estate, points to the risk of a significant reversal lurking around the corner. Such a drop in construction could amplify the contractionary effects of a real appreciation (once a downturn starts).

Immigration also plays a role. On the one hand, a large inflow of workers (net immigration in 2005 was 4.1% of employment) has helped to contain labour shortages during the current boom, reducing the pressure on wages and prices and, thereby, has acted as a macroeconomic adjustment channel like the one that operates inside the United States. On the other, however, new migrants also bias the mix of aggregate expenditures and, in particular, it has reinforced the demand for new housing, which is already overexpanded.

In short, Ireland watch out. While a correction of the housing market can be expected, a bumpy road along the correction path is clearly a possibility as perceived real interest rates rise back into line and the convergence process grinds to a halt.

The Italian Case
While Ireland soars, Italy suffers from sustained contractionary shocks. Increased competition from emerging market economies in the “traditional” sectors dominating the Italian economy has led to a fall in external demand, which appears to have deepened after 2002. Nominal depreciation would have provided a handy way to adjust to this new reality. Given the constraints posed by being immersed in a monetary union, real depreciation can solely be effected through lowering wages and prices. But, this being Italy, wages have not only not fallen: they have merrily continued to rise, speeding ahead of those of other eurozone countries.

This wouldn’t be too bad if productivity had risen accordingly. But, unlike Germany’s, Italy's productivity has fallen. And, to cap it all, the euro has strengthened steadily against other currencies, making Italy’s exports to US-dollar-denominated markets all the more expensive.

The result is a severe slowdown of growth and the widening of a deep divide between sectors that are exposed to external competition and those that are sheltered, the latter much less inclined to increase efficiency and cut costs.

The Italian government is currently implementing a small rebalancing of the tax burden through measures that reduce the effective payroll tax rate on non-financial firms (excluding public utilities) by approximately 3 percentage points. This is a step in the right direction, but it is clearly insufficient to address the country’s competitiveness crisis.

A further step should be for the government to speed up deregulation, reducing monopoly power faster in the sectors of the economy least exposed to international competition. An increase in efficiency and more competitive pricing in these sectors would clearly have large, beneficial effects on the sectors exposed to international competition.

But that is, of course, a highly political step. With a weak government and strong pressure groups in the nontradeable sectors, alas, also a very unlikely one.

EEAG Report on the European Economy 2007: Macroeonomic Adjustment in the Euro Area – The Cases of Ireland and Italy

• Visit the 2007 EEAG Report website
• See who the authors of the EEAG Report 2007 are