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Analysis/Comment Last Updated: Jan 9, 2015 - 5:23 AM

Dreams of European Growth: France and Italy facing pre-euro economic problems
By Michael Hennigan, Finfacts founder and editor
Oct 27, 2014 - 5:11 PM

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Dreams of European Growth: The European Commission is seeking adjustments in the 2015 budgets of France and Italy and while the governments of  both countries have embarked on economic reforms, they are dealing with challenges that pre-date the launch of the euro.

Germany, France and Italy experienced increases in debt and unemployment  in the 1990s, which ended with the launch of the euro in 1999.

France last had an annual budget surplus in 1974 but it was only in the early 1990s during the genesis of the euro project, that it allowed its economy to come off the rails with its sovereign debt as a ratio of GDP surging by almost two-thirds in 1990-1995.

The Italians had lost control of their economy earlier and the Basel I agreement, which went into effect in 1990, provided additional leverage for countries that wished to expand debt as the new rules for banks lowered to zero banks’ capital requirement on sovereign debt – no matter how risky.

Eurozone countries like Italy, Spain and Greece have had trade deficits with Germany since at least 1980 - 20 years before the euro launch. The International Monetary Fund (IMF) has said that the euro is a continuation rather than a structural break and the Fund's statistics show that since 1999, Germany's trade surplus with the rest of the world has grown faster than its surplus with the other Eurozone countries - and faster still with European nations that have not adopted the euro.

In 1980 Greek trade with was almost in balance. Since then the value of German imports from Greece hardly changed until 2005 while exports from Germany quadrupled.

In 1980, West Germany's exports to Italy as a ratio of imports was 111%; in 2010 Germany's was 130%.

In 1979, West Germany's exports of manufactured goods were double France's level. In 1988, 44% of the British trade deficit was with West Germany.

In 1981/82, 40% of the deteriorating French trade balance was related to West Germany.

Over the past hundred years, the German economy only during the Hitler regime (1933-45) did not have a reliance on exports. Between 1910 and 1913, exports accounted for 17.8% of Germany's GDP. Their share declined to 14.9% in the second half of the 1920s and fell to only 6% in the second half of the 1930s, but by 1950 accounted for 9.3% of West Germany's GDP. Once the postwar economic boom got under way, exports rose to 17.2% of GDP in 1960, to 23.8% in 1970, to 26.7% in 1980, and 25% in 1990.

In 2013 the following were the export/GDP ratios: Germany 51%; Spain 34%; UK 31%; Italy 30%; Greece 29%; France 27%;  US 14% and Ireland 108% in 2012.

The product mix, company structure, and both the number and skills of its exporters, make Germany an exports powerhouse.

79% of Germany's trade surplus in 2013 with 5 non-euro countries + France, Austria

France has run a continuous trade deficit since 2002. In 2013 and 2013 Italy achieved trade surpluses after a decade of deficits, partly because the poor economy has depressed imports.

Stagnation in the Eurozone as German aversion to inflation to continue

German industrial production may expand only ¾% in 2015

European Commission forecasts slow recovery with very low inflation

Weak and incompetent governments of the left and right operating in corrupt systems with limited transparency and where insiders have significant power, have been a feature of governance in France and Italy.

In the first 10 years of the euro, Italy’s gross domestic product increased by less than 3%; that of France, with about the same population, by 12%. The gap perfectly reflects the difference in hourly productivity - stagnant in Italy, up by 9% in France. Italy’s disappointing result applied to the country as a whole, North and South alike.

Mario Draghi, the outgoing governor of the Banca d'Italia, said in in 2011: "if productivity stagnates, our economy cannot grow. The productive economy loses competitiveness; widening deficits appear in the current account of the balance of payments. Foreign direct investment dries up. In the course of a decade, Italy received foreign direct investment inflows equal to 11% of GDP (gross domestic product), compared with 27% in France.

Wage growth is modest in Italy, as it cannot diverge too sharply from productivity growth: this has repercussions on domestic demand. The real earnings of employees in Italy have been virtually stationary over the past decade, compared with a gain of 9% in France; real household consumption, which has risen by 18% in France, has grown by less than 5% in Italy and only by eroding the propensity to save."

Reforms should extend to more than labour issues as rents, monopoly or near monopoly profits, and institutional shortcomings, also drag an economy down.

Sweden's Freedom of the Press Act of 1766 is regarded as the world's first Freedom of Information Act and Sweden became one of the world's wealthiest countries with the help of competent governments but economic systems do need retooling.

In 1980, the top Swedish marginal income tax rate was above 85%, and 74% of full-time employees paid marginal tax rates in excess of 50% while in the 1980's real wages stagnated (see chart above).

A banking crisis in the early 1990s triggered significant reforms including maintaining the welfare state on the sustainable basis for the long-term.

Golden growth

Once upon a time the Kingdom of Solovia was gripped by a great debate. “This is a growing economy but it can grow faster,” many argued. “Sustainable growth is best,” came the reply," and that can come only from natural forces."

A few called the debate growthmanship. But most thought it would be healthy if it led to a better understanding of Solovian growth. So the King appointed a task force to learn the facts of Solovian economic life.

So began a short article in the September 1961 American Economic Review titled "The Golden Rule of Accumulation."

Edmund Phelps, the author, won the Nobel Prize in Economic Sciences in 2006 for his work on growth and in 1961 he had proposed a simple rule for a nation's wealth to grow and provide the highest standard of living for its citizens - present and future. The rule specified how much people had to work, save, and invest today so that future generations could be at least as well off as they were.

In the same 1961 issue of the American Economic Review Robert Mundell, another American economist, outlined a theory of “optimum currency areas” -  it details the conditions that the countries in a monetary union have to have—or quickly institute—to share a single currency profitably.

Mundell suggested that that the single currency should not lead to persistently high unemployment rates in some parts of the monetary union, nor to unacceptably high rates of inflation in others. He argued for both capital and labour mobility.

In 1999, the year of the launch of the euro, Mundell was awarded the Nobel Prize for “his analysis of monetary and fiscal policy under different exchange rate regimes and his analysis of optimum currency areas.”

The single currency began with the three biggest economies representing two-thirds of the region's GDP, facing economic problems.

In a major report in 2012, 'Golden Growth: Restoring the lustre of the European economic model,' World Bank economists said that many economists still consider the golden rule the most basic proposition of  optimum growth theory. "It is the inspiration for the title of this report, and  forms the roots of its policy prescriptions. Following the golden rule means that today’s Europeans work and consume just so much that future generations do not resent them for consuming too much, nor pity them for consuming too little. Keeping to the rule is perhaps the most telling sign of a country’s — or a continent’s — economic maturity."

They said Europe’s growth is already different from other economies’ in two aspects, reflecting its cultural and demographic maturity. Perhaps more than others around the world, Europeans want economic growth to be smarter, kinder, and  cleaner, and they are willing to accept less for “better” growth. With the inevitability of ageing, Europe does face the new challenge of falling populations.

Golden growth: restoring the lustre of the European economic model

Input Papers

Country Benchmarks

The report looks at long-term growth in Europe, paying special attention to the last two decades, and identifies what needs to be done to assure continued prosperity in the decades ahead. It assesses the six principal components of the European growth model: trade, finance, enterprise, innovation, labour, and government. Its main findings: most countries in Europe are doing well in trade and finance, many in enterprise and innovation, but few are doing well in labour and government. So Europe needs many changes to make governments and labour markets work better, fewer changes to foster innovation and productivity growth in enterprises, and fewer changes still to reform finance and trade. Stalled productivity, declining populations, and unsustainable fiscal imbalances have made many changes urgent.

To revitalise the European growth model, the report makes three sets of recommendations: restart the convergence machine that has allowed poorer countries become high income economies; rebuild “brand Europe” that has helped the region, with one-tenth of the world’s population, account for a third of the global economic output; and reassess what it takes to remain the world's lifestyle superpower, with the highest quality of life on the planet.

The report says that between 1950 and 1973, Western European incomes converged towards those in the United States. Then, until the early 1990s, the incomes of more than 100m people in the poorer southern periphery—Greece, southern Italy, Portugal, and Spain—converged to those of advanced Europe.

Starting with the first association agreements with Hungary and Poland in 1994, another 100m in Central and Eastern Europe were absorbed into the European Union.Another 100m in the candidate countries in Southeastern Europe are now benefiting from the same aspirations and similar institutions that have helped almost half a billion people achieve the highest standards of living. If European integration continues, the 75m people in the Ukraine and other countries of the Eastern Partnership will profit in similar ways.

Indermit Gill, the lead author commented: "Europe spends more on social protection—pensions, unemployment insurance, and social welfare—than the rest of the world combined. European governments spend about 10% of GDP more than counterparts in other parts of the world, and almost all of the difference is social protection.  For many countries in Europe, this has become unaffordable. Combined with demographic pressures and weakened work incentives, this fiscal burden is now a drag on growth.”

According to the report, Europe will need to make big changes in how it organises labour and government, because of pressing demographic trends and persistent budget deficits. With a rapidly ageing population and falling fertility and without changes in employment, immigration, and pension policies, Europe will lose about one million workers each year for the next five decades and Europe’s labour force is projected to shrink from 325m to 275m.

At the same time, Europeans have been reducing how much they work.  Today, Americans work an extra month compared with the Dutch, French, Germans, and Swedes, and work noticeably longer than less well-off Greeks, Spaniards, Hungarians, and Poles. Men in Poland, Turkey, Hungary, and France retire more than 8 years earlier than in the mid-1960s.  By 2007, French men expected to draw pensions for 15 more years than they did in 1965, Polish and Turkish men more than a dozen. This puts enormous pressure on public finances, already strained by the costs of servicing large public debt.

Europe will have to work on many fronts to deal with impending labour shortages: increasing the competition for jobs, improving labour mobility, fixing how work and welfare are facilitated, and rethinking immigration policies.  These changes will need a new social consensus.

“When done well, reforms to labour markets and social protection systems mean that Europeans can work shorter hours per week and fewer weeks per year,” said Indermit Gill. “But it is impossible to balance public accounts if people also work fewer years over their lives.”

According to the Joint Research Centre (JRC) of the European Commission, over 50% of all US firms in the Top 1,000 global R&D spenders in 2009, were founded after 1975, in Europe the figure was 18% and in Japan just 2%.

Absolute convergence in Europe is mainly a myth as it is within countries.

Globalization's new normal needs permanent underclass - Part 1

Globalization, the underclass and the need for a new model - Part 2

Globalization, technological change and GDP's disconnect - Part 3

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