The eurozone’s economy has begun a fragile turnaround since European Central Bank head Mario Draghi announced late last year that the institution would do “whatever it takes” to backstop the euro. For the first part of 2013, that meant the economy was still losing ground – but at a slowing rate. The region finally reversed course and grew by 0.2% in the second quarter. But don’t expect that quarterly figure to climb much above 0.5% over the next year or two, which means a jobless recovery is likely. Knowledge at Wharton spoke with Wharton management professor Mauro Guillen to see where things are heading.
An edited transcript of the conversation follows.
Knowledge at Wharton: The 18-month recession in Europe looks like it has ended, officially at least. In the second quarter, there was growth of 0.2% — not a huge number, but certainly better than going down. In addition, manufacturing expanded for the first time in two years. But is that likely to continue? What’s your view of what those numbers mean? And the growth certainly hasn’t affected unemployment very much, yet.
Guillen: As you know, unemployment is a lagging indicator, and it takes much more than 0.2% growth to bring unemployment down. Europe has been going through a double dip recession, so there was one immediately after the financial crisis. And then there was a second one, and it has affected some countries of course more than others, especially the southern periphery.
Now, is this likely to continue along that slow growth trend? Probably yes. I’m not expecting in the next year or two or three for growth to accelerate. I’m not expecting a third dip, either. I think growth will probably stay within 0.2%, 0.5%, 0.6% or so for the next year or two until all of the economies in the area make adjustments.
Knowledge at Wharton: One worry is that this could be a jobless recovery, so that you have some economic improvement in certain indicators, but the one that really matters to most people is unemployment. What do you think the prospects are for a jobless recovery?
Guillen: Well, it will be jobless to the extent that it is so timid, so slow, right? If these economies were growing now at 2% or 3%, then I think we would see very quickly much more improvement of unemployment. But you’re asking a very important question, which is, prior to the crisis in some of these countries we had certain sectors of the economy that were employing a lot of people: retail, construction and so on. There’s still a big question mark as to whether retail will recover quickly, and that’s a major employment area in Europe, as it in the United States.
I think there’s also a huge question mark as to whether construction or real estate in general will again generate a lot of jobs. I think it is better to be cautious about the job prospects because, again, not all of the adjustments have been made. Not all countries in Europe have regained the competitiveness that they lost over the last 10 years before the crisis hit.
Knowledge at Wharton: The recovery is very uneven. France and Germany are doing reasonably well, whereas the southern countries, many of them — notably Spain, Portugal and Greece — are still struggling mightily. Could you talk about the prospects for those two blocks of countries?
Guillen: I would draw the map a little bit differently and for the following reasons. More than half of all the exports of European countries go to other European countries, and most of that to other eurozone countries. What we also know is that they all compete against each other in the same categories of goods. There’s tremendous overlap, especially between Germany on the one hand and France, Italy and Spain on the other. So of those four economies, which are the large eurozone economies, the one that has made the most adjustment so far is Spain — not enough, though, because Spain has regained about one third of the competitiveness that it lost before the crisis in the last 10 or 12 years.
But Italy has done very little. And as you know, politically, Italy is a big mess right now. France, incredibly, has actually regained no ground relative to Germany, although France and Germany overlap in 70% of the product markets in which they operate. That is to say, French and German companies compete head-on to a very large extent. So there are better signs in Spain than there are in Italy and France, although you are correct in saying that the French economy, surprisingly, has actually left the recession and now is growing.
Then when you look at the smaller countries like Portugal, Greece and Ireland, the one that has made the biggest adjustments is Ireland. So far it has regained maybe half of the competitiveness that it had lost, followed by Greece and Portugal. Portugal actually has regained very little. So remember, these countries need time to adjust because they could not devalue their currency…. In the absence of that, they need to do a very painful and very slow internal devaluation, which means they need to adjust their wages and they need to increase their productivity. That takes a while.
So far, what we see is that Ireland and Spain have made the most progress along those lines. Portugal and Italy have done the least. France actually doesn’t score that well, and neither does Portugal. So we start to see some difference. This does not mean at all that in France there’s going to be a big problem. All I’m saying is that they’ve lost some time. They haven’t adjusted yet. And the gap between, let’s say, German competitiveness and French competitiveness remains. They haven’t closed that gap. That’s what the latest numbers show.
“It is very important for these countries to regain their competitiveness, because they lost so much of it — not just to the emerging economies, but also to Germany, Holland and Austria, the competitive countries within Europe.”
Knowledge at Wharton: The countries you mentioned that are struggling, but have made some progress — not so much Portugal, but Greece and Ireland — they’re doing that through austerity policies, correct?
Knowledge at Wharton: If that austerity is going to work, if it’s going to bring them back to competitiveness, how much longer would that take? How long does this process have to go on? It’s been going on a very long time already.
Guillen: Well, the reforms that they’ve been implementing are not just trying to reduce the budget deficit. In fact, some countries have been much more effective at that than the ones that I mentioned. For example, Spain has not been very good at reducing the budget deficit. But is has been quite good at reforming the labor market and at reducing costs to the point that Spain actually prior to the crisis had a deficit in the balance of payments. That is to say, it was importing much more than it was exporting. And for the first time now in 25 years, as of the last few months, it is exporting much more than what it’s importing. And that’s a sign that they’re becoming more competitive, and companies are finding a way of selling outside of the domestic market. And, of course, the domestic market is very much depressed.
So, it really depends on what part of the economy you’re looking at. It is very important for these countries to regain their competitiveness, because they lost so much of it — not just to the emerging economies, but also to Germany, Holland and Austria, the competitive countries within Europe. So they need to regain that ground that they lost over the last 15 years. And, over the last two or three years with austerity policies, they’ve managed to close some of that gap.
But the interesting part of all of this is that they haven’t been able to really bring down the government deficit because they still have very high unemployment. So they have to spend a lot of money on unemployment insurance. But they have been able to close at least part of the competitiveness gap, and again the number one country in terms of closing that gap so far has been Ireland. It has closed about half of it. The second one is Spain. The third is, interestingly, Greece. Whereas France, Italy, Portugal have closed none of that gap, or just very little of it. So the disadvantage that they had three or four years ago — they’re still facing that same disadvantage. They haven’t adjusted. There are several things that you need to adjust here, not just the government finances, but also the labor market and also your costs. Because all of those things will, in the end, help you be more competitive.
Knowledge at Wharton: Two years from now, where do you think the eurozone will be growth-wise?
Guillen: It depends, in general, on whether [the eurozone] will exist. It depends on what mix of short-term and medium-term policies the governments agree to introduce. What we know is that for the eurozone to grow, we certainly need Germany and France, the largest economies, and Italy and Spain, to grow. So far, we have some growth in Germany, some growth in France, still not a lot of growth in Spain, although the direction of change is the correct one.
The biggest problem is in Italy, quite frankly, because Italy has not made adjustments. Politically, it’s very complicated. And you see Italy, of all of these countries, is the one that overlaps the most with Germany. Italy makes automobiles. They make machine tools. They make chemicals. They make all of the things that the Germans also make. So unless they change in a serious way, they’re going to have a lot of trouble because there’s another member country in the same trade block that is so much more competitive, and they virtually almost entirely overlap with them in terms of what they sell in global markets.
“The problem is that unlike the United States, the Europeans have been very slow at cleaning up the balance sheets of banks.”
Knowledge at Wharton: So, in some ways Italy is the country to watch over the next couple of years?
Guillen: I think right now. It is the country that I worry about, quite frankly. I wish the Italian economy the best, and I think it would be very good for the rest of Europe if Italy made progress in terms of becoming more competitive. But quite frankly, so far the figures don’t look good. And the other country for which the figures don’t look any good in spite of these very recent GDP growth number is France. Because France — for another set of reasons — has not really adjusted. It wasn’t that much under pressure from the markets as the other countries. It has been so much slower when it comes to making reforms and making adjustments so that it can become more competitive.
Knowledge at Wharton: In Europe, tight credit continues as banks are reluctant to lend. Is there any light at the end of this dark tunnel?
Guillen: Not yet. The problem is that unlike the United States, the Europeans have been very slow at cleaning up the balance sheets of banks — very slow, no matter where you look. Even in the healthy economies, [such as] in Germany, the banks are still saddled because they made many wrong investments, not so much in real estate, but rather in securities and some of those exotic instruments. And they also purchased quite a bit of bad government debt from southern Europe.
What we have in Europe is essentially a set of economies that are so much more reliant on bank credit. You see, the problem in Europe gets so bad and it’s so important because European companies rely on loans from banks to a much greater extent than American companies do, because here in the United States we have equity markets and bond markets that are so much more developed than in Europe. European firms depend on banking and bank finance to a much greater extent than American firms. And yet the European governments have been much slower at cleaning up the banks and making sure that they can go back to being the main source of funding for companies, giving credits. So this is a big problem.
And there’s another problem, which is that the eurozone needs in the medium run — three to five years from now, not immediately — to set up an institutional framework that can support the common currency. And that would be a fiscal union, as we know, on the side of government finances. But then on the side of the financial system it would be a banking union, that is to say a single supervisory authority. So that framework is still absent. There are a lot of conversations going on; there are a lot of negotiations. One would hope that a return to normal might be possible when they have those institutions in place. But that’s going to take, I think, three to five years.