For sustainable economic prosperity, Europe needs labor market reform and wiser government spending

Renowned finance and strategy professor James Ellert received an honorary doctorate from the Bled School of Business last month and was also voted the best professor of the past year by students of the one-year and two-year MBA programs.

We spoke with Professor Ellert on this occasion about current events in the global economy.

• How do you comment on the inclusion of the Chinese yuan in the International Monetary Fund’s basket of reserve currencies (SDR, Special Drawing Rights)? Although some consider it a symbolic move, it is nevertheless an important decision that signals a shift in the global economy?

– China aspires to replace the dollar with the yuan as the primary global reserve currency. Reserve currencies have come and gone throughout history, and it favors the yuan as the next logical reserve currency. In the 17th century, the Dutch guilder emerged as a global reserve currency due to the success of the Dutch East India Company, and by the 1860s, the United Kingdom had become the world’s largest exporter, making the pound the world’s reserve currency. After a brief return to the gold standard in the 1930s, the US dollar took on that role at the end of World War II. Over the past 20 years, America has recorded significant trade deficits, while China has emerged as a new global exporter, which is why it believes it is time for the yuan to replace the dollar. However, due to Chinese intervention in foreign exchange markets in favor of Chinese trade, Western governments are likely to resist this.
On the other hand, Brazil and Russia advocate for the creation of a synthetic currency that would replace the US dollar. Such a currency, an expanded version of the SDR, would include all global currencies, with each weighted according to its contribution to global export trade. This would mean that the euro, dollar, and yuan would have the greatest weight, but unlike the SDR, this currency would become the standard for balancing trade among countries, rather than just an additional reserve currency as defined and maintained by the IMF. In this sense, the inclusion of the yuan in the SDR is recognition of China’s export strength and somewhat legitimizes China’s desire to participate in the global reserve currency or even an exclusive role as a substitute currency. The change is therefore more than symbolic as it signals recognition of the shift in global economic power from West to East.

• What will happen to the European recovery given the apparent slowdown in China and developing economies? European exports largely depend on demand in those economies.

– It is important to understand why China is slowing down and how the Chinese response to this could change the composition of Chinese imports from Europe, North America, and other developing economies based on natural resource exports. In 2011, China reached a GDP per capita of over five thousand dollars. This level of success is still very low by Western standards, but historical data over the past few centuries shows that it is difficult for an economy to maintain double-digit GDP growth after GDP per capita reaches three to five thousand dollars in purchasing power parity. It is therefore not surprising that there has been a Chinese slowdown in recent years, which would have happened even without the financial crisis of 2008. Chinese economic growth has continuously slowed from 22 percent in 2011 to around seven percent last year.
The GDP of a country is composed of three elements – consumption, investment, and government spending. China has noticed an excessive emphasis on the investment component of GDP and now has significant excess capacity in its industrial sector. The difference between this country and mature Western economies lies in the 34 percent share of consumption in GDP compared to 70 percent in America, 59 percent in Japan, and 57 percent in Germany. With the growth of the middle class of consumers and weaker export demand, Chinese decision-makers hope to revive GDP growth by focusing on strengthening domestic consumption as the new engine of that growth.
If China is successful in realizing this recovery plan, it will have implications for the composition of exports to China. Intentional slowing of state investments in the industrial sector will continue to reduce Chinese demand for raw materials and sophisticated industrial goods. At the same time, such a development could open opportunities for exporting quality consumer goods in the mid-price range or for foreign direct investment in the production of such goods in China. Value-based tourism could also benefit from this. As in the case of China, the European recovery is likely to require a more robust domestic expansion of growth alongside export-driven growth.

• How do you view the European Central Bank, has it done enough and can it do more to stimulate recovery?

– I think the ECB has done what it could to stimulate the European recovery. Following earlier initiatives in Japan (since the 1990s) and the US (after the last recession), the ECB has created an environment based on zero interest rates without stimulating inflation, but low interest rates are not enough to stimulate consumer and investor demand. Consumers are still deleveraging, while larger companies are accumulating cash, buying back shares, and cutting costs to improve short-term profitability instead of aggressively increasing their investment budgets for growth.
The Japanese experiment is particularly significant in this regard. After a quarter of a century of zero interest rates, Japan has been unable to create a longer period of strong economic growth. Even with unprecedented monetary easing, the recovery in the US has been mild and slow compared to other recent recoveries in the American business cycle. Policies of easy money may have prevented a global depression, but they are insufficient to stimulate a rapid recovery.

• What do you think about the European economy, the recovery is slow, and austerity seems to harm it more than help?

– The European economy needs fiscal stimulus alongside monetary easing. Austerity was intended to address structural problems that many argued contributed to unsustainable levels of public debt. However, with austerity, public debt levels in the EU have not significantly decreased, and in some struggling countries, they are actually rising. Domestic demand is decreasing with austerity measures as households adjust their consumption habits due to job insecurity and wage losses associated with persistently high unemployment. High unemployment rates require additional government spending on unemployment benefits and other forms of transfer payments. Due to the reduced level of taxable personal income and profits in the business sector, state revenues are falling, and compensating through higher tax rates or reduced pensions leaves even less disposable income for spending. The result of austerity is therefore a negative spiral in the most affected European countries that turns into a vicious circle that is very difficult to break.
I agree that Europe needs labor market reform and wiser government spending to develop a foundation for sustainable economic prosperity, but it is a matter of time for implementing these initiatives. The EU is committed to a ceiling on government spending (relative to tax revenues) that applies regardless of current economic conditions. Why not consider counter-cyclical ceilings that would require countries to have budget surpluses (higher taxes than government spending) in years when economic growth and prosperity are forecasted, and allow deficits in periods of recession or slow growth when fiscal stimulus through government spending is most needed?

• Is the euro part of the solution or part of the problem? Generally speaking, countries with their own currencies have fared better than those in the eurozone, except for Germany, the Netherlands, or Finland.

– Historically, austerity has been successfully applied in countries with their own currency, which is usually devalued to promote export growth as part of economic recovery. EU member states have a common currency, but not a common exposure to deteriorating economic conditions. As you imply in your question, the current exchange rate of the euro favors Germany and a few northern countries that would face stronger exchange rates if the value were determined individually. On the other hand, the euro is too strong for weaker members to achieve a robust export-driven economic recovery.
Because EU members cannot devalue the euro independently to restore international trade competitiveness, internal devaluation often becomes a solution for the weaker among them. This means pressure on the state or private sector to lower or freeze wages in relation to developments in healthier member states. However, internal devaluation is very visible and attracts more attention from voters than market devaluation of a national or common currency.

• Banks in Croatia have signaled an unwillingness to further finance the state (more out of spite towards the state than business logic), citizens are still deleveraging, and banks remain skeptical about financing companies. Where will banks then invest money, can the private sector benefit from the accumulated cash available to banks, or will that money simply be drained away?

– It is now clear that Western European, Central European, and American banks achieved growth at the beginning of the millennium by providing risky loans without adequate pricing of those loans. This ultimately resulted in a high share of non-performing loans, erosion of bank capital, and bank bailouts with taxpayer money. Since 2008, banks active in this region have been under pressure to improve their capital relative to total assets they manage. Taxpayers are increasingly unwilling to approve bailouts for banks operating with too little capital to survive without that assistance in difficult economic conditions. Bank capital is an alternative buffer for absorbing future potential losses, so banks have been forced to increase their own capital relative to total assets they manage.
They finance their operations through debt (client deposits and other debt instruments) and equity. They have two ways to increase their capital percentage, one is to simply increase their capital, the other is to reduce financing through debt. Banks are reluctant to issue new shares at the moment because prices are low, so most have responded by reducing debt, which means reducing the bank portfolio in terms of not providing new loans or renewing existing ones.
I agree with you that this behavior is not in line with a recovery of the economy driven by the private sector primarily due to a lack of investment capital for promising small and medium-sized enterprises. The fact is, however, that we can expect further reductions in bank portfolios over the next few years due to banks struggling with increasing regulatory requirements for adequate capitalization. In that case, we should not expect significant improvement in the flow of new corporate loans within Croatia or the region in the near future. Capital markets, not banks, will be a major support for financing investment growth, and this development will favor countries like the US, which have large and deep capital markets for issuing and trading new corporate debt and securities.