Eurozone's rebalancing challenge

Regaining external competitiveness dented by a decade of massive external capital inflows, asset price bubbles, and investment booms, is arguably the biggest challenge facing many of the beleaguered Eurozone economies. Martin Wolf, quoting two Goldman Sachs research papers, “Achieving fiscal and external balance”, points to the magnitude of this re-balancing challenge facing the peripheral economies.

To achieve a sustainable external position, Portugal needs a real depreciation of its exchange rate of 35 per cent, Greece one of 30 per cent, Spain one of 20 per cent and Italy one of 10-15 per cent, while Ireland is now competitive. Such adjustments imply offsetting appreciation in core countries. Moreover, with average inflation of 2 per cent in the eurozone and, say, zero inflation in currently uncompetitive countries, adjustment would take Portugal and Greece 15 years, Spain 10 years and Italy 5-10 years. Moreover, that would also imply 4 per cent annual inflation in the rest of the eurozone.

But the danger is that even if the required inflation environments can be sustained for long periods, the austerity policies being followed by these economies could choke off any growth and push them down a contractionary spiral. Spain's targeted fiscal correction by 5.5% of GDP over two years, with 3.2% adjustment proposed for 2012, from its fiscal deficit of 8.5% of GDP for 2011, is one of the biggest fiscal adjustments ever attempted by a large industrial country. Such severe austerity threatens economies with large unmeployment rates, debt-ridden banks, and fiscally constrained governments. Predictably, as with the case of Spain, the markets have reacted with alarm driving up Spanish bond yields and CDS spreads.